Crypto Lenders Caused Crypto Contagion Last Year. How Is the Industry Rebuilding?

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The 'Wild West' era of crypto lending ended in a series of bankruptcies. Now the industry is attempting to rebuild in a sustainable and accountable manner.

Loans are as old as money. Throughout history, whether seeds or gold, every form of currency has had its lending market. Now, Bitcoin, with its decentralized and transparent nature, has staked its own claim in the financial landscape. And just like the currencies that came before it, for Bitcoin to truly thrive, it also needs a robust lending market.However, thus far, most attempts to create a bitcoin credit market have failed spectacularly, with disastrous repercussions.

This lack of oversight ultimately led to the collapse of the digital asset lending industry beginning in 2022, including the cascading bankruptcies of lenders including BlockFi, Celsius and a unit of Genesis. This outdated structure, coupled with insufficient risk management, was akin to dry wood eagerly awaiting a spark — and Terra/Luna, Three Arrows Capital and FTX were an entire box of matches.Historically, a lending model without ring-fenced risks is viable only when a lender of last resort exists, such as the Federal Reserve in the context of traditional banks.

By capitalizing on price discrepancies between different exchanges, market makers have been exceptionally effective in narrowing the bid-ask spread over time. This efficiency directly benefits consumers, ensuring they receive more dollars when they sell and more bitcoin when they buy and helping to stabilize bitcoin's price.

Another hazard lies in concentration risk from lending counterparties, or the firms crypto lenders would work with to generate yield on client holdings.When promised rates become unsustainable, these platforms face a dilemma: restrict lending to manageable limits and reduce client rates, or continue unchecked lending despite surpassing comfortable risk thresholds. Proper management of this concentration risk is fundamental to risk management.

 

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