Genesis Capital’s fall might transform crypto lending — not bury it

TradFi firms with expertise in risk management may soon “fill the void” left by bankrupt crypto lenders, a Duke finance professor predicts.

Is crypto lending dead, or does it just need better execution? That’s a question asked with more urgency in the wake of Genesis Global Capital Jan. 19 bankruptcy filing. That, in turn, followed the demise of other prominent crypto lenders, including Celsius Network and Voyager Digital in July 2022, and BlockFi, which filed for Chapter 11 bankruptcy protection in late November 2022.

Unlike many traditional creditors, like banks, cryptocurrency lenders aren’t required to have capital or liquidity buffers to help them weather hard times. The collateral they hold — cryptocurrencies — typically suffer from high volatility; thus, when markets plunge, it can hit crypto lenders like an avalanche.

Edward Moya, a senior market analyst at Oanda, told Cointelegraph, “The demise of crypto lender Genesis reminded traders that there still needs to be a lot more cleaning up in the cryptoverse. You don’t need exposure to FTX to go under and that theme might continue for a while for many distressed crypto companies.”

Echoing those comments, Francesco Melpignano, CEO of Kadena Eco, a layer-1 blockchain, expects to see “contagion from these meltdowns continue to reverberate this year and maybe the next few.”

‘It’s a failure of risk management’

Is crypto lending kaputt? It’s a question Duke University finance professor Campbell Harvey was asked lately. His answer: “I don’t think so.” He believes the business model remains sound and there is a place for it in future finance.

Many traditional loans today are overcollateralized, after all. That is, the collateral provided may be worth more than the loan, which is unnecessary from a borrower’s point of view and makes for a less efficient financial system. Of course, the problem with many crypto lending transactions is the opposite — they are undercollateralized.

However, a safe middle ground could be reached if one applies professional risk management practices to crypto lending, said Harvey, co-author of the book, DeFi and the Future of Finance. 

He believes that those bankrupt crypto firms failed to plan for worst-case market scenarios and it wasn’t for lack of knowledge. “Those people knew crypto’s history,” Harvey told Cointelegraph. Bitcoin (BTC) has fallen more than 50% at least a half-dozen times in its short history and lenders should have made provisions for significant drawdowns — and then some. “It’s a failure of risk management,” said Harvey.

Crypto lending firms also failed to diversify their borrower portfolios by number and type. The idea here is that if a hedge fund like Three Arrows Capital (3AC) collapses, it shouldn’t bring down its creditors with it. Genesis Global Trading lent $2.4 billion to 3AC — far too much for a firm its size to lend to a single borrower — and presently has a claim for $1.2 billion against the now-insolvent fund.

A traditional lender typically performs due diligence on a borrower to check out its business prospects before lending it money, with collateral often adjusted based on counterparty risk. There is little evidence this was done among failed crypto lenders, however.

What could explain this disregard for basic risk management practices?  “It’s easy to start a business when prices are rising,” said Harvey. Everyone is making money. It’s simple to push worst-case-scenario planning to the side.

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The appeal of crypto loans in good times is that they offer individuals or businesses liquidity without having to sell their digital assets. Loans can be used for personal or business expenses without creating a tax event.

Some suggest we are now in a transitional time. Eylon Aviv, a principal at venture capital firm Collider Ventures, views cryptocurrency lending as an “essential primitive for the growth of the crypto ecosystem,” but as he further explained to Cointelegraph:

“We are currently caught in transitional limbo between centralized actors [Genesis, 3AC, Alameda Research] that have a scalable solution with poor risk management and handshake deals that go belly-up; and decentralized actors [Compound, Aave] that have a resilient but non-scalable solution.” 

Wherefore DCG?

Genesis is part of the Digital Currency Group (DCG), a venture capital company founded by Barry Silbert in 2015. It’s the closest thing that the crypto industry has to a conglomerate. Its portfolio includes Grayscale Investments, the world’s largest digital asset manager; CoinDesk, a crypto media platform; Foundry, a Bitcoin mining operation; and Luno, a London-based crypto exchange. “One big question mark on everyone’s mind is what will be DCG’s fate?” said Moya. 

If DCG were to go bankrupt, “a mass liquidation of assets could deliver a shock to crypto markets,” said Moya of Oanda. However, he believes the market may not necessarily see a return to the recent lows, even though DCG plays a big part in the crypto world. Moya added:

“Much of the bad news for the space has been priced and a DCG bankruptcy would be painful for many crypto companies, but not game over for holders of Bitcoin and Ethereum.”

“It is rumored that the [Genesis] bankruptcy was part of a plan with creditors,” Tegan Kline, co-founder and chief business officer at software development firm Edge and Node, told Cointelegraph. Whether or not that is the case, “the filing means that DCG and Genesis are unlikely to dump coins on the market and this is one of the reasons that recent [market] price action has been positive,” said Kline.

Kline thinks DCG may have sufficient resources to weather the storm. It depends “on how well DCG can ring-fence itself from Genesis,” Kline added. “DCG has a valuable venture portfolio. On that basis alone, my bet is that it is likely to survive either by raising external capital or giving some equity over to creditors.”

A new wave of lenders

DCG aside, the crypto lending sector can probably expect some changes before the end of 2023. Harvey anticipates a new wave of crypto lenders emerging, spearheaded by traditional finance (TradFi) firms, including banks, to replace the now depleted ranks of crypto lenders. “Traditional firms with expertise in risk management will enter the space and fill the void,” Harvey predicted. 

These banks are now saying to themselves something along the lines of, “We have expertise in risk management. These lenders got cratered and there’s now an opportunity to go in and do it the right way,” Harvey said.

“I completely agree,” added Collider Venture’s Aviv, who believes TradFi may soon be rushing in. “The competition is well on its way for the highly lucrative lending market.” The main players will be centralized entities like banks and financial firms, but Aviv expects to see more players with decentralized protocols built on top of Ethereum and other blockchains. “The winners will be the consumers and users, who are going to receive better, cheaper and more reliable services.”

Shawn Owen, the interim CEO of SALT Lending, told Cointelegraph, “The emergence of traditional financial firms in the crypto lending market is a development we saw coming, and it showcases the growing mainstream acceptance and potential of this innovative industry.”

Few emerge unscathed

SALT Lending built one of the earliest centralized platforms to allow borrowers to use crypto assets as collateral for fiat loans. It has registered with the United States Financial Crimes Enforcement Network and has a history of third-party audits. While it doesn’t conduct credit checks on borrowers, it performs full Anti-Money Laundering and Know Your Customer verification, among other screenings. Still, SALT Lending hasn’t come out unscathed from the recent turmoil. 

The firm froze withdrawals and deposits to its platform in mid-November 2022 because “the collapse of FTX has impacted our business,” it said. Around this time, crypto securities firm BnkToTheFuture announced that it was ending its efforts to acquire its parent, SALT Blockchain. SALT Lending’s consumer lending license was recently suspended in California too.

We did not publish this as a notice of going bust. We are pausing to deal with the fall out of FTX and to confirm that non of our counter parties have any additional risks so that we can proceed with maximum caution with all efforts directed at not going bust. More info soon.

— Shawn Owen (@Shawn_OwenJ) November 15, 2022

The “pause” on withdrawals and deposits, as the company calls it, was still in effect early this week. However, a Salt Lending source told Cointelegraph that: “We’re in the final stages of going through an out-of-court restructuring that will allow us to continue normal business operations. We’ll have an official statement about this very soon.”

Still, amid all the upheaval, Owen insists that with proper management, the practice of lending and borrowing crypto assets “can be a valuable tool for achieving financial growth and stability.”

More regulation coming?

Looking ahead, Owen expects more regulation of the cryptocurrency lending sector, including measures “such as the implementation of capital and liquidity buffers, similar to those required of traditional banks,” he told Cointelegraph.

Some practices like rehypothecation, where a lender re-uses collateral to secure other loans, may come in for closer scrutiny. Owen also expects to see more interest in “cold storage” lending, “where borrowers are able to monitor their funds throughout the duration of their loan.”

Others agree that regulation will be on the table. “DCG’s debacle has [had] an incredibly detrimental effect on institutional investors, which also means that retail investors will feel the brunt of it,” Melpignano of Kadena Eco told Cointelegraph. “I would liken it to a one-two punch that will give regulators the ammunition they need to move aggressively against the industry.” He added:

“The bright side is the industry finally has a catalyst for clear regulations to enter the space — entrepreneurs will need regulatory clarity both to build the use cases of tomorrow and attract institutional investment.”

‘A poisonous drug’

Maybe it’s premature to ask, but what lessons have been learned from the Jan. 19 bankruptcy filing? The Genesis bankruptcy “reinforces the narrative that crypto lending should happen in a transparent manner on-chain,” Melpignano said. “For as dire as the situation may be for the industry in the short-run, on-chain lending protocols were unaffected by all of 2022’s unfortunate events.” In his view, this solidifies the use case for decentralized finance — a more transparent and accessible financial system.

“If there is a core lesson to learn from last year, it is not to idolize and trust ‘thought leaders’ and ‘talking heads,’” said Aviv. The industry has to push for “maximum transparency and audibility.”

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“High leverage is the most poisonous drug in finance, not only in crypto,” Youwei Yang, chief economist at crypto miner Bit Mining, told Cointelegraph. This is probably the most important lesson to be drawn, but the need for better risk management protocols is also now clear. People have learned that “loosening the standards during hyped [up] market conditions can be a disaster after the liquidity pulls out,” Yang added.

Stronger and ‘better prepared’

Aviv says crypto lending will survive the crypto winter “and come out stronger through the other side” by using on-chain assets “that enforce and simplify both audibility and regulation.” He expects continued innovation in this space, including “new forms of collateral like real-world assets, transparent custodians and enforceability via new account abstraction primitives.”

Overall, cryptocurrency lending remains a useful financial innovation, but its practitioners need to embrace some of the state-of-the-art risk management practices developed by traditional finance firms. “The idea is good, but the execution was a failure,” summarized Duke University’s Harvey. “The second wave will be better prepared.”