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Lending Your Crypto: Risks And Rewards Of Virtual Asset-Based Finance




The idea has merit. But know the risks and what happens when borrowers default.

Hats off to the lucky ones, the crypto investors who bought bitcoin before market prices began to slide in January 2018. Many did nicely, converted some of their holdings to fiat, and retained a sizable pile as a long-term bet.

Now what? How about earning an attractive interest rate on a small portion of those holdings by converting it into fiat and lending it out on a short-term basis to crypto holders who are underwater? Sure, there'd be taxes to pay on what is technically a securities transaction. But what if the interest received is lucrative enough to put that concern aside?

There are a number of crypto lending sites that stand ready to help. Most of those we reviewed charge borrowers interest in the 12-to-22 percent range. The implication is that the borrower is better off with them than a credit card cash advance, which could cost 25 percent or more on an annualized basis. The pitch may also appeal to an individual lender who disdains short-term crypto trading and believes their digital assets will pay off over a long-term investment horizon.

What follows is a discussion of the basic mechanics. But first a few cautions.

Default Risk

The borrower may be a person or small business that can't get credit elsewhere, for any number of reasons. The borrower may already have maxed out on credit card cash advances, have too much working capital tied up in accounts receivable, or be unable to obtain a term loan from a traditional financial institution. It's curious, however, that crypto lending sites tend to emphasize easy access to credit. Just one of many examples: "[Y]ou can instantly withdraw a loan. No credit check." The individual lender has to realize that loan default is relatively common among borrowers with no or low credit scores.

The borrower puts up collateral in the form of BTC or another popular digital currency such as Ether or Litecoin. The go-between platform may promise that the lender gets to keep or liquidate 80 percent of the collateral in the event of default. Assuming the lender has done enough homework and has selected a reputable lending/borrowing platform, the arrangement is basically a bet on the future price of the crypto collateral. That may be fine with the lender who is crystal clear on the default risk.

If the borrower defaults or disappears, in the scenario above, the lender is made whole if/when the price of the collateral asset rises to the level at which the sacrificed 20 percent of collateral is off-set. The key question here is: How long will that take? Months, years, decades, or whenever? Meanwhile, the platform company keeps that 20 percent to cover operating expenses and book as profit.

That causes one to wonder: Is the platform company aggressively chasing people who own crypto bought at or near market peaks? People already strapped for cash? Maybe the idea is to bring in borrowers who have no other choice and agree to pay interest in the 16-25 percent range. Traditional credit-card companies and payday loan outfits do this now.

Security Risks

Individual lenders do have to worry about the risks of theft, fraud, and cyber-attack. So, it's crucial to understand as much as possible about insurance coverage for stored collateral. Does the platform offer any insurance coverage of this kind? And what amount of the collateral that's put in storage for the individual lender is covered? Is it 100 percent for each lender? Or is coverage only extended to the pool of collateral stored on behalf of individual lenders – and if so, is there a maximum coverage limit for the pool? What if a lender with a big loss stakes a claim before others and maxes out the pool's annual coverage?

One lending/borrowing platform named SALT makes a big point of this in its marketing literature:

"A coverage limit shared by multiple clients of the policy holder likely does not equate to the total value of assets held on the platform to which the coverage limit applies. So, depending on how many assets are on the platform and how many clients share the coverage limit, maybe a percentage of your assets held on that platform would be covered in the event of theft or fraud, or maybe none of them would be."

Another question is whether a platform uses a third-party custodian to safeguard collateral assets. If there is a third-party custodian and that custodian has insurance, does that policy cover just the platform company or the individual lender as well? If that policy does extend to the platform's individual crypto lenders (highly doubtful), what does that coverage entail?

Another urgent question involves cyber-crime. In most instances, individual digital assets are not directly insured to protect against cyber-crime. When it comes to SALT, the platform is the entity that is protected from events such as cyber-attacks, hacks, or extortion threats, technology or professional error, among other things. The digital assets belonging to a SALT customer, however, are not directly protected. But SALT argues that it is differentiated from competitors because it has a comprehensive, professional grade safekeeping program that protects client information, company information, and the technology customers use to interact with their assets.

SALT: Food For Thought

Cleverly, SALT suggests that traditional credit scores don't matter all that much when the lending platform's underlying technology is blockchain-based. In its marketing material, SALT calls blockchain-based assets such as BTC "an ideal form of collateral." The company says it is using this feature to "dramatically reduce the complexity and cost of the loan process." Beyond that, SALT operates under Regulation D and, in lieu of credit checks, the company does AML and KYC verifications.

SALT's loans start at $5,000 and go as high as $250 million. Loan percentages run between 12 and 22 percent APR, but the borrower retains the value of the collateral currency, claiming any gains and losses that happen over the life of the loan.

If the borrower defaults or outright disappears, the lender may at least dream of future capital gains if/when the cryptocurrency markets spring alive and begin another prolonged upward trajectory.

Mary Driscoll

Mary Driscoll covers finance and business trends as a staff writer for ETHNews. She formerly served as an editor for management and finance at the Economist Intelligence Unit and a research principal at APQC. In addition, she has written for The Wall Street Journal CFO Report, HBR-online, and strategy + business. Her book on corporate treasury management was published by John Wiley & Sons, Inc. Mary enjoys hiking and skiing in the Sierras with family. Her goal in life is to win big on Jeopardy.

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