Where is the liquidity? Crypto lending explained

  • Crypto lenders offer returns on crypto deposits, such as stablecoins, by lending them with interest – similar to traditional banking practices
  • Crypto lending platforms are divided into two broad categories: non-custodial (decentralized) and custodian (centralized).

On June 13, 2022, Celsius investors woke up to an alarming statement from the crypto lending platform: “Celsius suspends all withdrawals, exchanges and transfers between accounts.”

For a platform that prides itself on its high returns without the issues of traditional finance, it left many wondering, “How does crypto lending really work and where did all the liquidity go?”

What is crypto lending and how does it work?

Let’s start with the basics. At first glance, crypto lending works the same as traditional banking, but for digital assets. Crypto lenders offer returns on crypto deposits, such as stablecoins, by lending them out with interest. The main distinction is in the type of deposit and the type of lender.

There are two very different categories of crypto lending platforms: non-custodial (decentralized) and custodian (centralized). Noncustodial lending is a new approach, while custodial lending uses the traditional model with slight variations. Celsius is an example of the latter. To understand why problems arise in the custodial loan model, we need to explain the differences in liquidity supply and collateral requirements.

Crypto Loan Categories Explained

Crypto loans on deposit (centralized)

Crypto lending on deposit looks and feels like a bank for cryptocurrencies – without the same regulatory oversight and consumer protections. It manages all deposits and loans on a centralized platform and an internal balance sheet. Anyone wishing to earn interest on their crypto savings sends their tokens to a custodial wallet address where they lose direct control of the asset. In return, the platform invests the assets at its discretion, whether through interest-bearing loans or alternative yield farming.

Noncustodial (Decentralized) Crypto Lending

A noncustodial lending platform enables peer-to-peer or peer-to decentralization-bowl ready. Unlike its traditional counterpart, it allows depositors (lenders) to retain ownership of their tokens – and the source of return is clear. Lenders earn interest and borrowers pay interest. Platforms can automate functions traditionally handled by banks or custodians using blockchain smart contracts.

Defined Crypto Liquidity

Crypto liquidity, as in traditional markets, is the efficiency with which any digital asset can be converted into cash or token equivalent – ​​without affecting the market price. Consider the total liquidity of the asset as a pool of water and the price of the asset as the level of the water. The larger the pool, the slower the level changes.

Stock markets traditionally measure cash liquidity, but crypto markets measure it across an ever-growing list of token pairs. This website can be difficult to follow, but it is essential to understand how crypto lending platforms maintain liquidity.

Where and how cryptocurrency lending platforms source liquidity

Noncustodial (Decentralized) Crypto Lending

Decentralized crypto lenders, such as Aave, source liquidity through a network of different liquidity pools. So, instead of lenders and borrowers setting the terms of their peer-to-peer loans, the protocol works by using automated smart contracts to set each pool’s interest rates.

Aave’s Liquidity Pool Protocol aims to incentivize outside lenders to keep liquid pools and borrowings functional.

For example, if an ether (ETH) pool is illiquid, these smart contracts will automatically raise interest rates to attract lenders to that pool and encourage borrowers to repay their loans. When lenders add ETH, they receive the token equivalent of Aave in the form of aETH. This asset is different from a wrapped token because there is no central custodian. Smart contracts hold ETH deposits and automatically reward the lender with loan interest.

Crypto Lending (Centralized)

In contrast, centralized crypto lenders such as Celsius source their liquidity from their centrally controlled total deposit pool. They manage interest rates and approve loans on a case-by-case basis. Unlike decentralized non-custodial lenders, centralized lenders return returns from various sources aside from interest payments. For example, Celsius invests customer deposits in what is called liquid staking.

Liquid Staking (stETH)

Because ETH staking on Ethereum’s Beacon chain locks ETH up to a future date – not yet set but expected to be mid-2023 – after the merger, Lido Finance offers stETH, a liquid derivative for ETH holders interested in staking rewards. The token allows holders to accumulate staking rewards while maintaining the flexibility to sell or transfer the asset. If they trade the token with someone else, the new owner can claim future staking rewards. Nansen Research reported that Celsius has a wallet containing more than $450 million in stETH.

Differences in Crypto Loan Collateral Requirements

Cryptographic guarantee is a borrower’s pledge of token assets or currency to a lender – in case he cannot repay his loan. The borrower retains ownership of the collateral as long as the loan is repaid with interest.

Traditional banking services typically require a small fraction of the loan as collateral and use borrowers’ credit scores to assess loan risk. Because crypto loans pride themselves on providing fast credit with no minimum credit score, they require liquid collateral in order to automate liquidations. So, instead of using your house as collateral, you would need to use stablecoins or other crypto-assets – although perhaps in the future it will be easier for anyone to tokenize the property. Since crypto markets are exceptionally volatile, lenders demand a higher loan-to-value (LTV) ratio (not to be confused with total value locked, or TVL).

I know, that’s a lot to take in – so let’s review:

LTV — A loan-to-value ratio is the proportion of the value of a loan represented by collateral. A 100% LTV ratio is a 1:1 ratio, which means the borrower is putting up the full value of the loan as collateral.

TVL — Total Value Locked is the total value of cryptocurrency locked in a smart contract and represents the health and liquidity of any decentralized exchange or crypto lending protocol.

Both categories of crypto loans require a high LTV, but they differ in how they measure, report, and enforce liquidations.

Crypto Lending (Centralized)

Centralized loans can use a variety of methods to monitor LTV. If a borrower’s LTV falls below the safe threshold, the centralized lender will notify the borrower that part of their collateral may be liquidated through a margin call. If the value continues to fall, the lender will automatically trigger a partial or full liquidation of the borrower’s collateral.

But with centralized lending, this collateral requirement does not directly protect depositors. Since centralized lenders mix deposits between various investments such as stETH and stablecoins such as Tether (USDT), depositors have little information about the total liquidity available on a centralized platform.

Celsius’s announcement suspending withdrawals on June 13, 2022 increased the selling pressure on stETH, pushing the price even lower than the price of ETH. Many have speculated that this discrepancy is what prompted Celsius to freeze the accounts. But because their total liquidity value is not public, there is no way to gauge what triggered the scare.

Noncustodial (Decentralized) Crypto Lending

Decentralized loans, on the other hand, are completely transparent. Any liquidity provider can view a platform’s TVL to gauge total liquidity and overall health. There are no alarming tweets that the core team has suspended withdrawals. There are oracle pricing and smart contract risks, but decentralized lending, in principle, is not exposed to the risks of a centralized custodian.

For example, when a lender deposits ETH into an Aave ETH liquidity pool, smart contracts make the liquidity exclusively available to ETH borrowers. No central entity can pick up the deposit and play with it off-chain.

Blockchain price oracles continuously monitor each borrower’s LTV ratios so that if there is risk of default, the protocol automatically liquidates collateral to protect the lender.

Liquidity Risks of Crypto Lending

Regardless of either category of crypto lending, each carries liquidity risks. In decentralized lending, price oracles can fail during market-wide liquidity crises, exposing liquidation to a price crash and forcing lenders to recover only part of their deposit. And in centralized lending, central players can invest clients’ deposits on leverage with the risk of draining too much liquidity from the platform.

In fact, liquidity issues on one side of the crypto lending world will often hurt the other. This contagion results from a complex interaction between wrapped tokens, staked ETH and stablecoins on decentralized exchanges such as Curve Finance.

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  • John Gilbert

    blockages

    Editor, Evergreen Content

    John is the Evergreen Content Editor at Blockworks. It manages the production of explainers, guides, and all educational content for all things crypto. Prior to Blockworks, he was a producer and founder of an explainer studio called Best Explained.

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