This report takes stock of the market structure and landscape of digital asset lending. It also gives insights into the state and outlook for its regulation.
Section 1 provides an overview on the current market situation. Several major crypto (lending) companies defaulted in 2022, and contagion is still spreading. While this has negatively affected digital asset lending in the short-term, the space has not lost its attractiveness.
Both, CeFi and DeFi lending entities provide the rails for capital allocation in the digital asset lending space, with the former still playing a more important role for institutional participants. However, the crypto ecosystem is capital inefficient. This opens several possible arbitrage opportunities that are reviewed in the following section.
Section two focuses on the digital asset lending market structure. After discussing the uncertain future of Genesis, a major provider of prime brokerage services in the digital asset space, the drivers for demand and supply of crypto lending are reviewed. Lending entities mainly allocate funds to four types of borrowers/venues: i) crypto companies, ii) retail clients, iii) blockchains with proof-of-stake as consensus mechanism that offer staking rewards, and iv) financial institutions and professional traders.
Finally, differences between CeFi entities and DeFi protocols are compared across the eight dimensions
- interest rate and maturity,
- user experience,
- customer base,
- collateralization, and
Section three sheds light on the current landscape of digital asset lenders, distinguishing between centralized and decentralized entities. The outlook for many CeFi lenders remains highly uncertain. By contrast, most DeFi lending protocols, some of which started to provide services for institutional clients, have fared relatively well during the 2022 turmoil.
A trend towards on-chain lending, which may be supported by three developments, seems to emerge. First, with the recent implosion of some CeFi lenders, transparency, which comes naturally with on-chain protocols, is top of mind for investors. Second, regulators are working on providing regulatory frameworks for the crypto space, including DeFi. This may further unlock the space for professional investors, in particular for on-chain protocols. Third, while not yet comparable to the CeFi experience, the DeFi user-experience is slowly maturing. This is necessary if an increasing amount of lending shall be carried out on-chain by investors, who may not always be familiar with the technological intricacies of blockchains.
Regulated lending entities whose business is carried out transparently on-chain may prove to be an area of strong growth going forward. Whether this happens through centralized players harnessing on-chain transparency for their purposes, or through decentralized protocols maturing and operating within a regulatory framework remains to be seen.
Section four outlines regulatory trends in the U.S. and provides an outlook on potential levers for an emerging regulatory framework for digital asset lending. Regulatory scrutiny is likely focused on the three dimensions i) digital asset lending (involving retail), ii) stablecoins, and iii) DeFi. Regulators will place high priority on companies that have allegedly caused significant financial losses for retail participants while operating outside the regulatory perimeter.
Focusing on the U.S., a consistent regulatory framework for crypto is still largely absent. This has led to a practice of ‘regulation by enforcement’. To determine whether a digital asset is a security, the SEC applies the Howey and Reve’s tests. Regulatory scrutiny led to three key state/federal enforcement actions in digital asset lending, affecting BlockFi, Celsius and Nexo. All three companies were handed cease and desist orders for part of their product offering.
To create momentum for an encompassing crypto regulatory framework, President Biden signed an executive order for “Responsible Development of Digital Assets” on 9 March 2022. Regarding crypto lending, regulation emerging from the executive order will likely touch on consumer protection. The section closes by outlining existing regulation for financial institutions in the traditional financial system (Basel III) to gauge regulatory approaches, which may be applied to bring similar activities in the crypto space into the fold.
Section five concludes.
The originally published version from 19 December 2022 was amended with additional company information from Matrixport on 5 January 2023.
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