Crypto Lending and the Search for Yield
February 01, 2022
Read Time 4 MIN
We explore crypto lending and where yield comes from, as well as the impact of Bitcoin and crypto price volatility and the importance of traditional credit analysis.
Earning Yield on Cryptocurrency
One of the more notable cryptocurrency developments in recent years is the ability to earn yield by lending digital assets, including Bitcoin and stablecoins, to centralized exchanges, OTC traders and decentralized finance (DeFi) protocols.1 The underlying sources of such yield include, but are not limited to, profits from the futures-based “cash and carry”2 trade. Given the persistent contango3 in the Bitcoin futures market, the annualized roll yield on such a trade has averaged 13.7% over the last year.4
Other sources of crypto yield include trading profits from the wide-ranging arbitrage opportunities in a still-fragmented exchange market, along with the commissions charged by decentralized exchange protocols to access borrow and lending liquidity. Those trading commissions are generally denominated in the “protocol” coin of whatever DeFi exchange facilitates the trade. This means that investors looking to cash out to dollars or stablecoins must often make a series of additional intermediate transactions, incurring even more trading costs that accrue to protocol value, and eventually, comprise the source of funds to repay dollar loans.
Put simply, since crypto enables micro-payments that were not previously economically rational, market participants trade more frequently. And with banks and many other financial institutions still unwilling and unable to touch crypto, a persistent shortage of dollars has created short-term lending opportunities above 8%, at potentially low volatility levels.5 As an example of the size of this market, Genesis, one of the largest OTC players, claims $150B in cumulative originations and a current loan book of $12.5B (Fig 1). VanEck participates in these “new finance” income markets via short-term loans to the larger corporate digital asset intermediaries through the VanEck New Finance Income Strategy.
Fig. 1. Crypto Lending: Genesis Cumulative Originations
Source: Genesis. Data as of 12/31/2021.
There are two primary risks with such a strategy: one macro and one micro. First, a sudden downdraft in Bitcoin and crypto assets could swamp multiple lenders’ value-at-risk models, causing mass liquidations and defaults across the space and invalidating the entire business model. In a way this is what happened to Lehman Brothers and the rest of Wall Street in 2008. Many bears who see no value in digital assets assume this end-game. And yet remarkably, despite five separate 35% declines in Bitcoin since the start of 2020, including two consecutive 30%+ intraday down days in March 2020, the ecosystem has never seen a major bankruptcy.
That resilience was tested yet again over the January 22-23 weekend, when algorithmic market maker and proprietary trading firm Tantra Labs reportedly liquidated after suffering “performance degradation” and failing to raise fresh capital.6 Still, as can be seen in fig. 2, there was no major liquidation cycle among BTC futures participants this time. Bitcoin price volatility may be high, but in relative terms it continues to fall (fig. 3). It seems the larger lenders are positioned for worse.
Fig. 2. Bitcoin Aggregated Liquidations
Source: Glassnode, as of 1/28/2022.
Fig. 3. Bitcoin Price Volatility & Performance vs. Nasdaq 100
Source: Bloomberg, as of 1/28/2022. Orange Line = Bitcoin Price / Nasdaq Price. White Line = Bitcoin vol / Nasdaq Vol.
The second major risk to a lending strategy such as this involves the individual counterparty and its unique risk management processes and abilities. Better-capitalized counterparties with emerging brand value are likely to shield their lenders from some losses by smoothing out the more volatile rates in DeFi. This allows them to capture healthy spreads in both good and bad markets but also use financial resources when necessary to support franchise value and maintain good relations with the fixed income markets via attractive yields.
Certainly there is plenty of leeway on this front: for context, Coinbase’s ROA (return on assets) is 7.8% in 2020, and JPMorgan’s is 1.3% in 2021.7 We believe traditional credit analysis, supplemented by NDAs, is possible in this market, and we talk regularly with potential borrowers to discuss their own onboarding process, loan approval process, loan durations, position monitoring, concentration risks, worst case scenario-modeling and more. Given the high single digit yields we observe at extremely low volatility levels, the opportunity cost of not doing this work is too high.
Though decentralized finance platforms continue to take market share in global trading (fig. 4), the vast majority of the world’s banks still won’t touch them. JPMorgan Chase just shut the personal bank account of Uniswap’s founder.8 The result is a shortage of USD in the crypto ecosystem and an attractive risk/return profile in the short-term lending markets. And though some yields have fallen alongside the collapse in Bitcoin futures contango, we expect our fundamental approach to counterparty analysis in this space will continue to produce attractive risk adjusted-returns for our clients.
Fig. 4. Decentralized Exchange to Centralized Exchange Spot Trade Volume (%)
Source: TheBlock, as of 1/28/2022.
Fig. 5. Bitcoin: Futures Annualized Rolling Basis
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1 Decentralized finance (DeFi) protocols are software programs that run on top of another cryptocurrency as a means to automate a financial service without a centralized institution.
2 Cash and carry is an arbitrage strategy that involves the mispricing between a futures contract and its underlying asset.
3 Contango is a scenario in which the futures price of a commodity is higher than the spot price.
4 Glassnode, 365-day moving average as of 1/27/22.
5 VanEck research.
6 The Block “Crypto trader Tantra to liquidate”.
7 Source: latest filings, Coinbase full year 2020, JPMorgan full year 2021. JPMorgan’s 2020 ROA was 97bps.
8 Source: Twitter, 1/23/2022 update by user @haydenzadams.
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