The secret to making crypto backed USD loans work

There is a lot of hype surrounding long term crypto holders that borrow cash using their crypto holdings as collateral in order to access liquidity. This allows them to remain invested and avoid potential capital gains tax claims. The ‘çrypto backed lending market’ that facilitates these loans is attracting many new entrants and volumes are rising. One big risk causes a lot of potential participants to shy away from this market; in case of a large price drop more collateral might be required and the resulting margin call can result in serious risks for both lender and borrower. We propose combining crypto backed loans with relatively cheap put options to neutralize the risk of a large price drop. This means the borrower will always be able to pay off the loan and the loan effectively becoming risk free for the lender. The feared and loathed margin call mechanism can be dispensed with all together.

At the end of March 2018, as much as 77.9% of the surveyed crypto investors were very optimistic and expected the crypto market to rise in value over the next three years, according to The Huobi Crypto Investor Index. This positive sentiment also raises a potential challenge for crypto holders – how could they spend some of the money they made without having to pay a lot of tax and losing access to future price appreciation?

Over the past 6 months  a number of crypto backed lending platforms emerged to help out with exactly this problem. These companies give crypto owners the possibility to maintain ownership of their cryptocurrency assets, while using their coins and tokens as collateral for (usually) a US Dollar denominated loan.

How do crypto backed loans work

The model of these platforms is very simple – the borrower transfers a portion of his or her crypto holdings to the platform, where it is stored in a cold wallet as collateral for a cash loan. The interest rate is usually between 10 and 20% and the term of the loans varies between 1 months and 5 years.

To protect the lenders, the value of the crypto collateral exceeds that of the loan. In most cases the so called loan to value ratio is between 40 and 60%, but it can be as low as 20% and as high as 80%. A loan to value ratio of 40% means that the loan amount is only 40% of the value of the collateral and the value of the collateral can drop by 60% before repayment of the loan is at risk. Putting it into numbers: if a borrower wants a loan of $50,000, he or she would have to provide crypto asset collateral worth $125,000.

If the borrower stops making payments, the lending platform can sell the collateral, and this should cover the loan. Additionally, if the value of collateral decreases below a certain level, say $75,000 for our $50,000 loan, there will be a margin call after which the borrower has 48 to 72 hours to bring the loan to value ratio back in line by either depositing additional crypto collateral or by making an additional cash principal payment. If the borrower does not satisfy the margin call the lender will pre-emptively sell the collateral to cover the loan. This type of selling is often done in falling markets and can realize large losses for the borrower. It also exposes the lender to large losses if the value of the collateral drops below the value of the loan during the margin call period and the borrower does not have the desire or the ability to post more collateral.

Nevertheless the crypto backed lending market has been gaining tremendous interest and volumes are rising.

Current crypto backed lending environment

The most mature companies in this space are Nexo and Salt Lending. Salt Lending is the oldest company in the space, it funds the loans by letting accredited investors invest in new loans through a fund structure. The administrative requirements to close a new loan can take quite long to complete. Nexo lends out its own money and applies a lot of automation. This improves the servicing time and a loan can be originated relatively quickly.

Some of the most popular active crypto backed lending platforms are compared in the table below:

Even though total reported volume is still below USD 100 million, crypto backed loans have been gaining popularity and lending platforms report loan demand significantly surpassing supply. From December 2017 till the 23rd of February 2018 Salt Lending has reported loan requests for a total amount of 1.3 billion USD when they halted new applications. They had only managed to close slightly more than $23 million at this point, mainly because of administrative restrictions.

How derivatives could kick start the crypto backed lending market

We believe the crypto backed lending market is still quite inefficient. The risk of having to face a dreaded margin call in the middle of a major downward price move is sure to scare away borrowers. At the same time lenders are not too happy with the risk that the collateral ends up being worth less than the loan amount in case the borrower not making a margin call.

The crypto derivatives markets seem to offer a cheap and safe solution to effectively insure the value of the collateral. This will ensure the borrower can always repay his or her loan, without any margin calls being necessary.

This miracle can be achieved with an instrument called a put option which can act as an insurance policy for the collateral. A put option is the right to sell the crypto asset used as collateral at a pre-determined price, called the ‘strike’ price. This means a put option insures the option buyer against the market price dropping below the strike price; if the price ends up below the strike the buyer of the option would simply exercise its right to sell the asset at the strike level.

In the case of a crypto backed loan puts could be used to insure the collateral value at a price level that ensures its value never drops below the loan amount. The premium that needs to be paid for the options will in most cases be significantly smaller than the interest rate charged on these loans.

Example

Say a lender executes a $50,000 loan with a borrower either directly or through a peer to peer platform. We assume the loan to value ratio is 40.0%, the interest rate clocks in at 14% and we assume an end date of December 28, 2018 for the loan. All prices are from the 13th of July at 14:00 hours CET.

Next the lender buys put options in order to protect the value of the collateral. The Deribit crypto derivatives exchange offers options that mature in December 28, 2018.

In our example, the lender would be at risk when the BTC price would drop more than 60%, i.e. below the $2,500 level.  This means we have to choose the strike of the put we are going to use to be as close to that level as possible and then we need buy enough options to hedge the entire loan: 20 options at a strike of $2,500 brings us to $50,000.

With the put options added to the mix, the value of the collateral can not drop below the loan amount making the loan effectively risk free and leaving the borrower in a much better position. There would normally be a margin call if the value of the collateral drops below a certain value (say $75,000) but thanks to the put options margin calls are not needed anymore.

Note that this also means that the borrower now has the guarantee that there will always be enough funds in the collateral account to repay the loan. This means the borrower now has a much more attractive product; without an intimidating margin call and with a repayment guarantee.

It is clear that the put option makes the product a lot more attractive for the borrower. Since the lender is paying for the option, the interest rate the lender receives could probably go up somewhat. But even assuming the current prevailing interest rate on such a loan the transaction allows for a 7.45% annual excess interest for the lender which is almost risk free.

Maturity and Crypto Limitations

A drawback of the current options market is that the longest dated put options mature on December 28, 2018. This affords a maximum of a half year of protection and limits the maturity of a protected loan. Another concern could be liquidity, which can be relatively low for out of the money put options. Option market liquidity is rising quickly however and decent bids are usually filled by parties arbitraging the options market.

Another limitation is that long dated options are still only available in Bitcoin. Deribit – currently the most liquid crypto options exchange – is planning to offer more crypto’s and longer dated product soon however. Other exchanges are also rumored to start offering options on multiple crypto’s. One remaining risk, and the reason we say ‘almost risk free’ loan, is the risk related to failure of the derivative exchange where the option is bought. You basically want your insurance company to be there when you need it. This makes it certainly advisable to select a stable, established exchange to transact the options on.

Conclusion

Derivatives turn out to be an effective way to make crypto backed loans almost risk free for both lenders and borrowers. Taking away so much risk should also allow loans to be approved more quickly and increase the transaction speed for the borrowers. We believe this will entice more lenders and borrowers into the market and allow the crypto backed lending market to really take off.

 

 

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