What is Crypto Lending? How is it Creating Problems For Coinbase?
On September 8th 2021, Brian Armstrong, the CEO of Coinbase, made news by criticising the way the US Securities and Exchange Commission (SEC) dealt with the company’s cryptocurrency lending product.
Just a quick primer on the who’s who. Coinbase is the largest cryptocurrency exchange in the US by volume and listed on Nasdaq earlier this year. Recently, it sought the approval of SEC to launch Lend, a feature that allows its customers to lend their USDC (a stablecoin pegged to the USD) for 4% annual interest, which is 8x what savings accounts offer in the US on average.
The SEC not only disapproved but it also said it would sue Coinbase if it launches the feature. Coinbase stock has lost close to 9% in value since.
But why deny? Coinbase says it is because the SEC considers Lend to involve a “security”, something the company doesn’t agree with. But given the absence of any statement to the effect yet, the overall reason behind the nix is largely unclear.
Let’s try to understand what lies at the heart of this issue and whether it may affect crypto investors in India.
What is Crypto-Based Lending?
At the core, it involves borrowing money with cryptocurrency as collateral. Many Decentralised Finance (DeFi) platforms or crypto exchanges offer loans by accepting cryptocurrency assets (Bitcoin, altcoin, stablecoin, etc.) as collateral. Unlike regular loans or credit cards, it doesn’t require a credit score. Instead, the lender usually checks your loan-to-value (LTV) ratio. Loans are usually given at an LTV ratio of 50–65% of the pledged cryptocurrency’s price.
Although the loan terms vary across platforms, there are two major categories of crypto lending. One is through custodial (CeFi) loans which are granted by a centralised authority (like BlockFi) which holds the collateral. The second is through non-custodial (DeFi) loans which rely on smart contracts found in blockchains like Ethereum. These can’t lend fiat currencies directly but they give out stablecoins which can be exchanged for cash.
The upsides of these loans are low-interest rates (compared to personal loans and credit cards), no credit check and fast funding. Downsides are volatility, absence of insurance and minimal access to holdings while your crypto assets are tied up as collateral.
Speaking of volatility, one may wonder how this works with the ever-fluctuating value of cryptocurrency. This is where the LTV ratio comes into play. If, say, your collateral is in Bitcoin and the price of Bitcoin drops, then the LTV ratio goes up, the collateral’s value goes down and vice versa.
If LTV increases too much, the lender may liquidate the collateral or ask the borrower to put more Bitcoin as collateral. The lender may also sell some of the Bitcoin to keep the LTV down. Conversely, if LTV decreases (due to Bitcoin price rise) then your collateral value goes up and you can take out more cash against the added value.
Ever since economies came to a snapping halt after the pandemic and interest rates were slashed, people started looking for other ways to earn interest. Crypto loans became a quick and easy way to gain access to fiat currencies, particularly, for unbanked consumers who couldn’t meet the lending criteria of traditional banks.
Vauld, Crypto.com, BlockFi, Nexo, Blockchain.com, ZebPay etc. Are some platforms which allow Indian borrowers to avail credit against their crypto holdings. The annual interest rates on crypto loans range between 4% to 15%, depending on the type of crypto asset collateralised. There are no overhead charges (like processing fee or foreclosure charges) either.
Crypto Lending vis-a-vis Securities?
Coinbase’s argument is that its lending program doesn’t qualify as a security, meaning that customers won’t be “investing” in the program but simply lending the USDC they hold in their accounts. Moreover, they will earn interest and the platform will ensure the security of their principal while also upholding an obligation to repay their USDC on request.
Even though the SEC hasn’t formally clarified on the matter, it has long argued that digital assets are similar to investment contracts or “securities” based on a legal theory known as the Howey Test. It says that “anything that gives investors the expectation of profit from the work of others” qualifies as a security.
From Coinbase’s perspective, the classification of Lend as a security would bring it under elaborate regulation and closer scrutiny, thus inconveniencing its unrestrained operation. In contrast, both historical experience and regulatory cynicism have perhaps taught the SEC not to make high-yield deposits like crypto loans unregulated.
Especially when the target customers are naive retail investors and the interest payments rely on immensely risky speculative investments. In any case, the anonymising and fundamentally borderless features of cryptocurrency make it harder to gain regulatory trust.
To top it off, events like the growing number of cyberattacks, extreme market volatility and technical fallouts could endanger the public’s deposits if entrusted within the crypto framework. Higher yield is good but perhaps not worth putting one’s investment at the imminent risk of a crash, or as in the crypto-verse, at the risk of Elon Musk’s tweeting habits!
The bankruptcy of Cred — a centralised crypto lender — in November 2020 is a case in point. A mix of fraudulent conduct, mismanagement and bad investment choices left nearly $100m worth of depositor’s money in the lurch. More recently, regulators cracked down on BitConnect, an online crypto lending platform, for fraudulently selling securities in the form of investments in a lending program.
Yet another concern for regulators is the growing practice of “yield farming”. This is a crypto investment strategy which involves “stalking” or lending crypto assets to generate higher rewards in the form of additional cryptocurrency. Basically, it is an innovative yet risky way of “growing crypto” that has helped balloon the DeFi sector’s market cap from $500m to $10bn in 2020.
Naturally, the incredible risks and the susceptibility to hacks makes the process extremely unpredictable and not very pleasing to the regulators.
Crypto Lending in India
BlockFi launched its crypto lending platform in India in 2019. Today, there are at least a dozen such platforms operating in the country. Some like Vauld have experienced heavy growth (60x in the last 12 months). The absence of capital gains liability, reduced fees and higher returns has continued to fuel the growth of crypto lending in India commensurately.
Even though there is a fair chance of regulatory spillover from the US resulting in SEBI (or RBI) invoking stricter norms for crypto loans in the future, the regulatory perception is materially different. Neither the regulators nor the Government see cryptocurrency as a security in India, rather as a currency, an asset class or a commodity.
Hence, their operation could be regulated on the same lines as digital loans offered on online wallets or UPI-enabled platforms.
However, more clarity on their governance is crucial going forward, in order to safeguard depositor’s interests and public money at large. While cryptocurrency’s contribution to revolutionising alternate finance has been remarkable, with each passing day, crypto enthusiasts seem to reach newer heights of incredibly questionable and risky financial behaviour. Only a well laid-out regulatory framework can quell this risk frenzy and secure markets.
(Originally published Septemebr 15th 2021 in transfin.in)
