What Is Lending Borrowing In Crypto? On Lender <> Borrower Dynamics In Crypto Through The Lens Of An Institutional Investor.
What are the main trade-offs, negotiating points, and moral hazards? One rule that governs it all – “there is no free lunch”.
Let’s break down the terms of trade. Loan to value = how much you borrow / how much assets you post for it. Usually, people borrow USD and post BTC / ETH / FTT (lol) or borrow coins and post USD. As for rate, you want to pay as little as possible and the lender wants to charge as much as they can get away with. There are a few more, but they are less important ones.
The institutional borrowers market is small in the number of firms but is huge in appetite to borrow.
All lenders compete for the same client list. Most of them are venture-backed and optimize for growth by all means. They originate as much as they can to get an up round. What can possibly go wrong if you are in search of borrowers to quickly deploy Bns of $?
The largest players have the best creditworthiness and the greatest thirst for borrowing. But they are all different in risks they take. Every lender was dying to have Three Arrow Capital (3AC) as their client since they were moving real size. You can see how moral hazard comes into the picture. Short-term incentives stand in the way of long-term ones, people get overexposed to bad actors with poor risk management. This story is not crypto-specific (think Bill Hwang) and generalizes way beyond. So what is the exact problem and why is it a hard one to solve? Why does it keep on happening?
1. Terms of the deals are bespoke as each borrower is different size, risk profile and etc.
Furthermore, assessment is often more qualitative than formulaic and data-driven. Much of it is based on relationships and trust which is always biased.
2. Assessment is based on lagged non-standardized data that is susceptible to the weapon of mass destruction – accounting engineering.
Lenders perform assessments based on the data they are given. And data they receive is optimized to get the best terms for the borrower.
3. Data privacy.
Lenders rarely get good visibility of the leverage firms run at. Even if assets can be evaluated more or less (but not even as 3AC case shows) liabilities are much harder to show. Another central piece is that none of the trading firms want to disclose more than they should. Why socialize alpha?
Just like TradFi firms massage the data for quarterly filings, so do crypto firms. Another central piece is that none of the trading firms want to disclose more than they should, as they each supposedly should have some alpha and they surely don’t want to publicize it.
Hence it is all tricky. One idea that I am thinking about recently is the use of Zk (zero-knowledge) proofs for addressing this issue. If one can assess the risks of one’s portfolio without disclosing individual positions that is powerful. Using this lenders could be much more thorough in their risk assessment, and not offer more leverage than one is entitled to given risk profile. This will create a more even playing field for everyone and price credit risk much more precisely.
Lenders could assess risks in real-time and be data-driven. For example questions like stats on exposure per exchange, total liabilities, equity, how much delta at coin/portfolio level, drawdown and etc. There are similar solutions already, but they lack rigor and scale.
You want several of the top lenders to start using such a service so that it hits escape velocity and becomes the industry standard. Then, borrowers will have no choice but to comply.
This is powerful as lenders could be much more thorough in their risk assessment, and not be offered more leverage than one is entitled to given risk profile. This will create a more even playing field for everyone and price credit risk much more precisely.
This will lower the overall fragility of the system and improve liquidity as good actors – firms with the proper risk-management framework, good execution, and business framework will get access to the cheap leverage they need, while punters will get none.
As one of my mentors used to say “Three things kill a trade: liquor, drugs, and leverage”.