30 November 2023

After a Quiet Year, Digital Asset Lending Must Come of Age

By Martin Garcia, Co-CEO, VersiFi

2022 was a watershed year for the digital asset space, with several of the industry’s most established names flaming out in dramatic fashion – and the lending market was no exception. The demise of FTX left several firms unable to meet their obligations to creditors, leading them to declare bankruptcy and placing profound constraints on both the institutional side (Genesis) and the middle market (BlockFi/Celsius). The fall of Three Arrows Capital, precipitated by the Terra/Luna collapse, created a crisis of confidence in lenders’ ability to monitor and effectively manage collateral. Other players met their end due to toxic combinations of commingling, rehypothecation and general mismanagement.

2023 was a much quieter year in crypto – perhaps a healthy development for everyone’s blood pressure, but not for the market at large. Lending is absolutely critical for the growth of a robust trading ecosystem, but while some crypto-native firms have dipped their toe back into these waters, much of the activity has been tepid at best. With limited access to funds – combined with a lack of regulatory oversight and a general negative sentiment stemming from the turmoil of the past 18 months – most institutions have remained on the sidelines.

That hesitancy is incompatible with transformation. To help this asset class reach its full potential – with all market participants and industry stakeholders able to access the diversification, flexibility and potential for returns it offers – the largest players need easy, responsible access to digital assets. In many ways, the opportunity to lay a foundation for a new wave of institutional crypto adoption, supported by sound lending practices, has never been greater – but it’s going to require the market to mature, and fast.

How? By applying all the lessons we’ve learned from recent years.


Four Keys for Crypto Lending’s Coming-of-Age Story

Digital asset lending has some growing up to do, and the best way to accomplish that is to look at the markets that have come before it. Some of the practices outlined below might seem straightforward – but if they were really that obvious, the market turmoil of 2022 would have played out much differently. By adhering to the below principles, lenders can ensure that institutional borrowers’ first steps into digital assets are on stable ground.

  1. Stay in Your Lane – The events of 2022 were caused in large part by firms that sought to be all things to the entire market, creating perverse incentives. In traditional finance, prime brokers commingle and rehypothecate client assets only under strict controls and oversight – if they also had exchange arms (as many now-defunct players in crypto had), the potential conflicts would be overwhelming and potentially disastrous. Digital asset lending desks must follow this lead. While the current state of the crypto ecosystem means there might be times when lenders must manage collateral, the long-term bent must be toward partnerships and triparty custody agreements, with collateral managed away from both borrower and lender. This way, business can proceed amid a much wider range of market fluctuations, with both lender and borrower protected from one another.
  2. Overcollateralize and Overcommunicate – There’s no way around it: it’s going to take some time for institutions to get fully comfortable in this market. In the early stages, focusing on robust disclosure and sound risk and collateral management will be key. That means overcollateralizing loans and making sure all counterparties are crystal-clear on exactly what is happening to their assets once in custody. Down the line, enabling borrowers to leverage their balance sheets and utilize their assets on-exchange while still in custody will be an important priority as the market matures. Whatever form that takes, it must be defined by careful governance and painstaking communication of the relevant asset flows and relationships.
  3. Embrace Technology – Agreeing on best practices and healthy frameworks is one thing. Having the tools necessary to abide by them is another. Digital asset lending desks need the tools, alerts and risk controls to assess the health of any given loan in real time. When working with third-party custodians, that means making sure all technologies are properly integrated, with universal visibility among all stakeholders. These firms must also have the capabilities to seamlessly translate these insights into action, whether that’s a margin call, liquidation or other risk mitigation strategy.
  4. Center the Human Element – While TradFi players aren’t strangers to fast-moving markets, their initial forays into digital assets will likely warrant a high-touch approach. Crypto lending transactions can be highly bespoke, and many institutions will only feel secure in moving forward by working closely with market structure and liquidity experts (this is why we see less institutional adoption in DeFi, and more handholding of institutional investors by DeFi sponsors). With the ability to pick up the phone, articulate their needs and secure a clear explanation of how the lending counterparty will help them achieve best execution and efficient borrowing, these firms can transact with confidence.


The Future: A Foundation for Regulation

We’ll close with a few thoughts on how this responsible lending model might point to the future of digital assets. This industry has shown a remarkable hunger for regulation – institutional players overwhelmingly want a defined framework so they can feel confident in where and how to conduct their business. Certain regions have been more active on that front than others, but with disagreement both among and within jurisdictions, there is an overall cloud of uncertainty.

Innovation shouldn’t have to wait for that clarity to come, much as we might want to align their schedules. So what’s the way forward? Our answer: stability, judicious management and an unwavering prioritization of client interests. By abiding by the principles outlined above, lending desks can inspire more institutions to get into the market in the short term. This will yield a surge in activity that will fuel even greater adoption, create demand for more innovative products and increase the pressure on regulators to provide true oversight. Finally, with clear frameworks for crypto regulation in markets around the world, the floodgates will open and digital assets will become as ubiquitous and accessible as their traditional counterparts.

It adds up to a virtuous cycle of adoption, and responsible lending is a key ingredient. This industry has been through a lot in just a few short years, but sometimes hardship is the best teacher. It’s time for digital asset players to put these lessons to work and write the coming-of-age story that this space so badly needs.

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