The Black Swan

by Mar 20, 2020Blog0 comments

*I wrote this article over a month ago to accompany our 2019 Q4 Crypto Credit Report. However, it seemed too alarmist and a little bloated so we decided to shelve it for the time being. Doesn’t seem too alarmist now. Throughout the article, I will be commenting on how many of these points have fared in the wake of an actual black swan event.*

Over the course of compiling data  for this report, we inevitably see recurring trends that pop up across the industry. For this issue, the role of exchanges and OTC desks  in crypto lending is becoming harder and harder to ignore. We’re seeing volumes increase on DEXes like dYdX and nüo, on centralized exchanges, like Bitmex and Coinbase, and even across OTC desks. Many protocols in DeFi have reported that over ⅔’s of their “borrow” volume comes from margin trading which has balanced out the previously disproportionate ratio between suppliers and borrowers. Similarly, firms such as Cryptolend and Templar Fund have built up fairly large AUM by giving their users returns on their crypto. This is accomplished by lending funds to exchanges like Bitfinex, BitMEX and Poloniex for margin trading (in the case of Cryptolend) or performing market making trades (in the case of Templar Fund). 

Firms like BlockFi, Nexo, Cred and Celsius jumped into the institutional lending market  in late 2018 / early 2019. All 4 firms demonstrated massive success in the consumer lending and quasi-banking realm. Yet clearly the returns, whether due to volume or quantity, were not enough to keep up the high growth rates expected or consistently provide their customers returns. The tremendous volume in the institutional world presents the perfect opportunity to increase the size of their loan books as well as generate interest that can be paid back to lenders. Many, if not all, of these loans are made to provide liquidity to execute massive, market making trades.

So why does this matter in context of this report? 

In traditional finance, credit can be assessed by evaluating the successful repayment of a loan, and the use of the loan comes into play when dictating terms. Whether it be a credit card, a small business loan, a car or a house, the diversification of one’s credit history has a large impact on their ability to access credit in the future, but crypto lending does not have this diversification. While there are cases of crypto loans for traditional use cases (cars, houses, businesses) the majority of loans are used to speculate. A common practice is to use a volatile asset, like ETH or BTC, as collateral against a fiat or stablecoin loan. This is then used to further go long on ETH or BTC on an exchange. Many sophisticated traders will only go 2x leverage while others will take huge risks at much higher leverage. History shows that the sophisticated trader generally makes out better and is clearly a better candidate as far as credit is concerned,  but this behaviour goes unnoticed by most. Crypto exchanges boast some of the most sophisticated liquidation algorithms designed specifically to manage risk associated with margin trading. Yet, these algorithms are still dependent upon a segment of users behaving rationally and managing their own risk with responsible amounts of leverage. If every trader used 100x leverage and the price falls too sharply, there would be hell to pay.

*This might be the most important point I made. BitMEX alone reported almost $700 million in liquidations as BTC crashed last week with 90% of those coming on long positions. Without accurate reporting on how leveraged certain traders are, it is impossible to predict the effects of a black swan event.*

In traditional finance, margin trading has no effect on credit scores outside of the most egregious  liquidation cases. Margin is collateralized with cash or different securities… In crypto, if a trader  goes long or short on BTC with any kind of leverage, the collateral being put up for the trade is also BTC which, in the case of large price drop, could have massively negative effects.  

It’s not news that crypto exchanges are a big deal. The exchange is an instrumental tool in regards to price discovery and  has allowed crypto currency to become a viable financial instrument over the last 10 years. But at some point in the next 10 years, we need to  find other viable options for profit and growth that don’t involve trading on every fluctuation on the price of BTC. Otherwise, the health of the entire crypto industry will be beholden to the whales who have shown the ability to manipulate BTC price to benefit them whenever necessary [site article here]. In the meantime, the strengths of blockchain, namely the transparency of transactions, should be leveraged in order to keep the flow of funds through exchanges as public and accurate as possible. 

Currently, it is impossible to find accurate and consistent volumes for exchanges and, much like crypto lending, the terms and vocabulary used by each individual firm creates an environment where it’s hard to find any meaningful consensus. Transparency of held assets is also crucial to maintain trust amongst the industry. Institutions invest across a diverse range of markets, not just digital assets. Transparency of those positions is paramount for a healthy crypto market. As a result of the lack of faith in exchange volume,, traditional regulatory bodies like the SEC will not approve BTC as an ETF, which puts a hard ceiling on growth for the crypto industry [site Coinbase article].

*Again, transparency among exchanges is absolutely crucial. The lack of builtin security features (such as circuit breakers at CME and NYSE) mean that there is no failsafe for massive selloffs. As a result, it is important for exchanges to understand their own risk as well as the industry’s as a whole. Without transparency among all exchanges, the industry leaves itself at risk to attacks like Maker DAO’s recent meltdown where liquidations occurred without spending any DAI.*

Compared to legacy finance, one of the touted advantages of crypto is the relative ease in which you can track your assets. Firms need to be making this easier instead of trying to obscure their users data  [site article]. While many institutions do their own audits of counter parties, these processes should be public and normalized in a way that avoids creating a bubble that approaches danger levels without anyone having an idea. Our goal for the CCR going forward will be to try and capture as much of this data as we can in addition to our efforts with lenders.

*Recent events only emboldens our efforts to make crypto lending as transparent as possible. Now wash your hands.*

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