Is the crypto lending market a time bomb?

Charles McKay wrote in his book "The Bizarre Mass Illusion and Group Madness" published in 1841: People think in the herd and go crazy in the herd, but they slowly recover one after the other reason. Even today, this passage still works.

Cryptocurrencies have deserved the craziest collective drug abuse in the past 10 years. Over the years, we have witnessed the impact of the encryption industry, such as exchange hacking attacks, Ponzi schemes, and so on. Despite the controversy in the crypto industry, in the long run, cryptocurrencies still have more advantages than disadvantages to the global financial market structure.

But when there are some unknown and shaky signs on the surface of the credit market, people's sensitive nerves are often triggered, and various doubts are highlighted. Since 2018, the market value of cryptocurrency lending has grown to 5 billion US dollars, and this growth trend continues. But blind expansion caused some problems, and users seem to smell a long-lost sense of crisis.

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Historically, every credit market had a bubble at a certain stage, until the bubble burst, tearing a long mouth. Therefore, crypto lending is likely to be the next bubble market.

The basis of crypto credit

Encrypted credit refers to using digital assets as collateral and lending funds, which is very similar to the traditional credit model. However, the problem lies in the underlying assets of encrypted credit.

In addition to stablecoins, the biggest reputation of cryptocurrencies is volatility. In other words, the encrypted credit crisis may be more destructive than the subprime mortgage crisis. Even in the worst financial crisis, when the bank ’s investment portfolio is millions of worthless properties, people will know that at some point, the market will recover. Even if real estate cannot be 100% callback, at least part of it will be callback. Crypto assets are highly volatile, and the entire credit crisis is a giant storm. It is a long night waiting for the sun to rise again.

Bitcoin's frequent price spikes and sudden spikes, an exchange attack, a scam similar to PlusToken, a massive sell-off, etc., may cause fatal damage to the crypto market. From the perspective of crypto lending service providers, the vulnerability of cryptocurrencies is worrying.

In the case of a sharp market decline, the rate of depreciation of the lender ’s assets. Depending on the speed of the market decline, the lender may not be able to provide more margin, so the service provider liquidates all the collateral on the lender's book. If a large number of loans default at the same time, service providers will follow a large number of sell-offs, which will further aggravate the market downturn.

Shortage of risk control tools

One of the main selling points of these loan service providers is that they do not conduct credit checks, so everyone can borrow. In other words, the only real risk control tool for crypto credit is the loan-to-deposit ratio indicator, which estimates the amount of collateral that lenders should deposit. Assuming that the loan-to-deposit ratio is 50%, and the lender wants to borrow a loan worth US $ 5,000, he should provide US $ 10,000 worth of collateral. Once the loan-to-deposit ratio exceeds the 50% limit, the lender will continue to deposit collateral or sell part of the cryptocurrency to repay the loan. Otherwise, it will trigger the collateral automatic settlement mechanism.

In order to reduce the risk of collateral default, some loan service providers even set the loan-to-deposit ratio at 20%, which became an excess guarantee. In the event that cryptocurrencies fall sharply and the loan-to-deposit ratio rises sharply, the only consequence is liquidation of collateral. However, the value of the collateral at that time may already be much lower than the outstanding value of the loan. In addition, when the number of buyers is too small, several lenders defaulted at the same time causing huge selling pressure.

In fact, the role of loan-to-deposit ratio is to reduce losses, not to prevent breach of contract. In other words, lenders and lenders are equally vulnerable to market unpredictability.

System importance risk

Currently, loan service providers only focus on niche markets. However, if it penetrates into other areas, such as exchanges or banking, then isolated issues may lead to market importance, which may lead to a downward spiral in the market.

(First position: market-important financial institutions refer to banks, insurance companies, or financial institutions that may lead to a global financial crisis due to their own loss of control)

However, the development of the encryption industry is closely related to the system. At first, experienced investors such as hedge funds were attracted by the volatility and high returns of crypto credit, a niche market. Now they retain more market-neutral positions, use lending services to balance their portfolios, and manipulate Bitcoin and altcoin shorts and longs. As the credit market matures, it becomes more and more similar to the bank's foreign exchange market (the US dollar is the base currency, and other fiat currencies are the secondary currency). In the crypto market, Bitcoin is the base currency and altcoins are the secondary currency.

The rapid expansion of the crypto credit market has attracted a group of new companies that are optimistic about this niche market. The crypto industry can only keep up with other credit markets.

Competition is further intensifying, and the only way to attract new customers is to relax the loan policy. The risk of loans increases and the probability of default increases. Let's return to the discussion we just started-the question of asset fundamentals, and whether deposits can guarantee the stable operation of loan service providers.

Do we need to worry?

It is too early to draw a conclusion. Before the bubble burst, the impact of the credit crisis was only hypothetical. Take the subprime mortgage crisis as an example. Under the surface of constructing a new product and credit default swap market, no one knows the impact, only that this niche market is booming, and buying a house is as simple as buying ice cream.

If unfortunately, the encrypted credit market is broken, the worst case is that, on the one hand, some loan service providers default, that is, those service providers that loosen their loan policies, and their customers face losses. On the other hand, if the market's interconnectivity and the risk of volatility spillovers increase, then there may be a domino effect, and volatility will spread to the entire system. The most likely to be implicated are hedge funds that hold large exposures to digital assets.

(First position: risk exposure refers to unprotected risk, that is, the credit balance that may be subject to risk due to the debtor ’s default.)

In short, everything depends on the size of the crypto credit market and whether it can penetrate other markets. At present, the size of the credit market is still very small, with daily bitcoin transactions between US $ 500 million and US $ 1 billion. In contrast, the trading volume in the foreign exchange market is estimated at US $ 6.6 trillion per day. However, given the current rate of expansion, the cryptocurrency market may soon become part of the global financial system.

To put it bluntly, the prerequisites for the outbreak of the crypto credit crisis are all complete, such as the lack of supervision, everyone can make loans, no due diligence, and the focus is blind optimism. The last time in history when these conditions were met, the financial crisis came.

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