Get 10%+ on Your Crypto! But is it worth the risk?
In November 2020, Cred, a crypto lending company filed for bankruptcy. They had been offering customers 4–10% APY on their crypto deposits, then suddenly, it was gone.
Cred suffered from a series of missteps that led to losses of $80–90 million of depositor’s funds. They had lent to a fraudulent fund, Quantcoin, and engaged in a series of risky loans in China by providing funds for derivatives traders, further they had lost customer money through a hack at a third party wallet provider.
Despite all of this bad press, the crypto lending industry continues to grow.
Get Cash without Selling Crypto
In a world of record low interest rates and negative yielding junk bonds, crypto lending platforms have arisen to provide investors with steady, high yields on cash and crypto assets. These yields are incredibly enticing, particularly with rising inflation and interest rates on savings accounts that can’t keep up.
By placing your funds in these interest bearing accounts, you are lending money to the platform. They turn around and lend your money out to others at a higher interest rate, then pay you the difference. Moreover, you can borrow against your crypto assets and get paid out in USD to make large purchases, all without selling your assets.
Keep in mind, if you are being paid interest on any asset: you are the lender.
You’re making a loan to the crypto lending platform with its own terms and conditions associated with it. Be sure to read the fine print to understand what you can and cannot do once you move your assets to one of these platforms. As a lender, you need to start thinking about the credit risk of your borrower — the crypto platform.
Any loan officer at a bank is going to do some due diligence. They’ll look at your credit history, ask about your income, and want to know what you’ll use the money for. All of this is to determine what their risk is before they hand the bank’s money over to you.
So put on your loan officer hat and ask yourself those questions. If you’re opening an account you should understand if they’ve defaulted in the past, how they are making money, and who they’re lending money to. Moreover, questions about jurisdiction, insurance, security, and business viability arise when assessing credit risk.
The last thing you want is to have your crypto sitting with another Cred that will take risks you’re not comfortable with and wind up losing your funds.
What risks are you taking?
Nothing is risk free. Even the “risk-free asset” par excellence, US government bonds aren’t risk free, even if i̶n̶v̶e̶s̶t̶o̶r̶s̶ academics act like it is. While crypto lending through major platforms like BlockFi and Celsius feel like low risk, easy money, it’s worth examining before you put your money to work on these platforms.
Banks and lenders want to see that their borrowers have some form of backing or collateral on their loans. This helps reduce the risk to the banks in the case that the borrower can’t repay their loan and defaults — they can get something back.
Consider a mortgage loan as a classic example. When you take out a mortgage to buy a house, the bank uses the house as collateral for the loan. If you can’t repay the loan, the bank takes the house and will try to resell it to get as much of the money back as possible, frequently at foreclosure auctions. Banks typically lose money on this process versus you paying off the mortgage and you’re out on the street.
Additionally, to reduce risk, banks require a down payment which reduces the loan-to-value ratio (LTV) of the loan. A 20% down payment gives the bank a LTV of 0.8, meaning that the collateral is worth more than the amount of the loan.
Most crypto platforms utilize similar techniques to reduce their risk. One of the biggest players in this space, BlockFi, offers three LTV levels for a crypto loan with different interest rates. The lower the LTV (i.e. the more collateral you post) the lower your interest rate.
Per the BlockFi contract — as is the case with most other crypto lenders — all collateral is held by them (section 5a if you’re interested). If you deposit funds with BlockFi, this ought to make you feel comforted because they hold the power when lending your funds out to individuals in case they default. Additionally, there are margin protections built into the contract.
Crypto is very volatile, which means the value of loans can fluctuate wildly, which can cause the LTV to shift as well. If it moves too far against the borrower, meaning the LTV rises too high, these platforms will issue margin calls, meaning the borrower must put up more collateral to bring the LTV back into line per the contract, otherwise the platform will liquidate their collateral to cover the loan.
Let’s walk through an example with BlockFi, which has a 70% maximum LTV ratio that must be maintained (section 6a in the contract). Say Jenny borrows $25,000 when BTC is at $50,000 with a 50% LTV. In this case, she puts up 1 BTC and gets $25,000 in cash deposited in her account.
The next day, the price of BTC jumps up to $60,000. Jenny’s LTV is now at 41.7%, and she can sleep easy knowing that she doesn’t have to sell her crypto to cover the loan. Over the next few weeks, Bitcoin takes a beating and the price falls to $35,000. Jenny’s LTV has risen to 71.4%, and she is likely getting emails to increase her margin by putting up more crypto to bring the LTV back into line.
BlockFi will give Jenny 72 hours to increase the collateralization of her loan, otherwise they’ll sell some of that collateral on the open market to bring it back to the 70% maximum. If it ever reaches 80%, then they automatically sell a sufficient amount to get the loan back in line.
Lenders do this to protect themselves from default, which is great for you as a depositor and provides a degree of safety on your balances.
Many of these platforms also engage in uncollateralized lending. This is giving out a loan simply with a promise to repay. This is the kind of lending that occurs when you use your credit card. Because there is no protection apart from the faith and credit of the borrower, interest rates on these loans tend to be much higher than for the collateralized variety.
We’ll keep pointing to BlockFi here — they’re one of the most transparent crypto lending platforms out there — because they too engage in uncollateralized lending. They do not allow retail borrowers to access these loans, they are reserved for institutional borrowers such as market makers, hedge funds, and the like. Institutions that typically have over $100 million on their balance sheets and are engaging in market neutral strategies, i.e. strategies that will pay out whether or not the price of Bitcoin increases or decreases.
Additionally, institutional borrowers are getting BTC, ETH, etc. from the platforms (with and without putting up USD as collateral), whereas the retail borrowers put up crypto to get USD.
Is your platform extending credit or engaging in its own speculation in the DeFi space? Yield farming has become popular among crypto enthusiasts looking to make an extra return, but this comes with its own set of risks. Moreover, platforms may be taking on high amounts of leverage to engage in this practice. If this isn’t something you’re comfortable with, be sure that the platform you entrust your crypto with isn’t engaging in this type of behavior either.
While Bitcoin hasn’t been hacked, there are countless stories of people losing their keys or accidentally exposing their secrets to malicious actors. The larger the exchange or lending platform, the bigger the target it is for hackers.
Do some research into the platform’s security. Do they custody the coins themselves? Do they place your coins with a third party? If so, are they reputable third parties like Genesis or Coinbase?
Not your keys, not your crypto! These centralized lending exchanges require you to put your crypto on their platforms, meaning you have no control over your keys. If your chosen platform is fraudulent, then you’re likely out of luck and will have a very difficult, if not impossible, time recouping your losses.
You can reduce this risk via due diligence into the platform. Just because there’s a flashy app out there promising 10% APY on your Bitcoin holding, doesn’t mean they’re legitimate. Look into the company.
- Find publicly available filing and incorporation documents.
- Are the people involved legitimate? Research the founders and find employees on LinkedIn and other sites to see if these are real people.
- Has the company been backed by VCs or other investors who have done their own due diligence, or is it a fly-by-night start-up? If professionals have backed it, then it’s significantly less likely to be a fraud.
- Are they being reported on by reputable news outlets? Assuming the news is positive, more corroborating evidence helps reduce your risk of being defrauded.
Jurisdictional and Regulatory Risks
Crypto is gaining adoption and acceptance around the world, however some governments and regulators remain highly skeptical; China seems to ban it every few years and India did the same recently. Your lender makes a prime target for government crackdown and restriction. If this were to happen, you may lose your crypto when they’re put out of business.
Check the location of your crypto platform before diving in and do some research regarding their local regulations.
Cash at your typical bank is insured by the FDIC up to $250,000 (although, with a 1.3% reserve ratio there are legitimate questions about the ability for the FDIC to actually pay out if a major bank fails). This insurance gives depositors comfort in case the bank becomes over extended and cannot meet depositor demands.
There is no FDIC for Bitcoin or crypto currencies, but it is still possible to have these deposits insured by a reputable insurance company or bank. Look into your crypto lending platform to see if they are insured to try to mitigate risks.
Business Model Risk
Even with the safety of over collateralized loans, it very well could be that the market could crash quickly and you’d lose your savings. The “safe” US housing market crashed in 2007–08 and brought many banks and lenders down despite the fact they were sitting on physical homes (e.g. collateral).
Moreover, many of these platforms offer both collateralized and uncollateralized loans. What’s the ratio between the two? How much of their balance sheet, i.e. your crypto, is actually at risk? Does most of their business come from riskier trading strategies and investments, or from safer sources?
This risk is, unfortunately, much harder to get your arms around because many of these companies are not fully transparent. You don’t know how much risk they’re really taking or where their loans are actually going. For the time being, the best you can do is read everything about the platform, listen to interviews with employees and founders where they discuss their business model. Keep in mind that they’re appearing on podcasts or writing articles to promote their company — so you’ll likely hear an overwhelmingly positive discussion! Regardless, know their bias and ask yourself if you’d trust them with your hard earned money.
Who would borrow at these rates?
Paying 9.75% interest seems astronomically high with 30-year mortgage rates near all time lows, US 10-year bonds under 2%, and over $18 trillion in negative yielding bonds, including junk bonds! So again, why would anyone be willing to pay that crazy rate?
Taking out a loan is not a taxable event and paying interest on a loan garners a tax deduction. This is crucial for many long-term investors in Bitcoin.
Let’s revert back to Jenny, our crypto investor above. She first bought Bitcoin back in 2016 at $400. She bought 10 BTC at the time, so her total investment was $4,000. Now, if Bitcoin is at $50,000, she has $500,000 to her name after a 1,240% increase in her investment! On one hand, If she wants to buy a house for $250,000, she would have to sell 5.75 BTC to cover the 15% capital gains tax (assuming she’s in the middle income bracket).
On the other hand, she could take out a loan at 9.75%, keep all of her Bitcoin, and the $250,000 she gets into her account is not taxable. Additionally, if the Bitcoin price increases between the time she takes out the loan and when she has to repay it (assuming no margin calls in between), she could pay off her loan by liquidating fewer than the 5 BTC required. Ideally, she probably wouldn’t want to sell any of her BTC, but it allows her to have her house and remain exposed to the BTC upside and the home’s potential appreciation.
In fact, leveraging of assets is how many of the super-wealthy avoid paying significant taxes. As long as their assets continue to appreciate, they can keep this game going more or less indefinitely.
Clearly, long-term crypto investors have a major incentive to borrow against their assets in this fashion.
Others who are taking out loans may be HODLers who have a need for some cash now. If you believe that Bitcoin is going to $100k, $200k, or over $1 million in the next few years, you don’t want to give up any of your real estate on the blockchain. Borrowing against it, however, can give you some cash now to meet rent when you’re in between jobs, pay for medical expenses, or whatever you might need in the meantime.
Crypto trades around the clock and with a lot of volatility, which provides significant opportunities for traders to cash in on its movements. One of the most popular trades of the past year is the Bitcoin contango trade in the futures markets. This trade has been able to return 20, 30, and even 40% annualized to traders with very little risk. If you have a winning strategy with minimal risk, the optimal decision is to trade larger with leverage. Thus many traders and institutions are doing exactly this. They’re happy to pay 10%+ to take out a Bitcoin loan if they know they can get a 30% return on the deal!
Know your Tolerance
Risk tolerance is a very important and personal issue. Far too many people approach these 7, 8, 9% yields as if it’s risk-free money, when in fact it is far from it.
There are a number of good, reputable companies out there who offer this service — I have money with some myself — but you must do your own research and due diligence before wiring money over to these institutions. You’ll never be able to eliminate risk, but you can mitigate it and be informed about your chances of loss.
Let Cred be a warning that fraud and mismanagement do exist, and put an effort into learning about any platform before you open an account. After all, nobody cares more about your money than you do.