The Block Report Interpretation: The current digital asset lending situation and the outlook for 2023

Abstract

1. By studying the driving factors of demand and supply for crypto asset lending, as well as the key differences between centralized and decentralized lending, the structure of the lending market is demonstrated.
2. By describing the key essence of the cryptocurrency lending field, an overview of digital asset lending is provided.
3. The Block report points out the current regulatory trends in the United States regarding crypto asset lending.

Introduction
In 2022, the defaults of several major cryptocurrency companies such as Celsius, FTX, and Three Arrows Capital (3AC), as well as the ensuing turmoil in the cryptocurrency industry, have highlighted a key area that has played a significant role in the industry’s tremendous growth in recent years: digital asset lending.

In a broad sense, digital asset lending refers to allowing funds to be allocated from lenders to borrowers in the cryptocurrency field. The Block’s report uates the market structure and situation of digital asset lending at the end of 2022. It also provides insights into its regulatory status and prospects. However, it is important to note that the focus highlighted in The Block’s report is explicit lending rather than implicit lending, such as that provided by perpetual futures and other derivatives.

The growth of the crypto asset space and the flow of venture capital are on the rise.

The total market capitalization of crypto assets increased from $19 billion in early 2017 to $0.9 trillion at the time of The Block’s report. In the first half of 2022, $18 billion in venture capital was invested in crypto assets and blockchain projects. This significant figure accounted for approximately 13% of the entire venture capital funds. However, in 2020, “only” $6.5 billion in venture capital flowed into crypto asset startups. Nevertheless, the challenging situation in the crypto asset market in 2022 is likely to result in a slowdown in financing.

Similar to the traditional financial (‘TradFi’), the borrowing and lending track is the way capital is allocated in the crypto space. The operation of centralized lenders is similar to traditional companies, with centralized decision-making power, while the goal of decentralized lenders is to operate as decentralized autonomous organizations (DAOs) and provide platforms primarily operated by code. Since most centralized lending companies are private and do not disclose their financial status, it is difficult to obtain indicators reflecting the scale and composition of their loan portfolios. However, there are some numbers that can reflect the growth of digital asset lending. For example, Genesis, a central entity that regularly provides data on its lending business.

The chart above shows the loan issuance situation of Genesis over a period of time. The quarterly loan issuance by Genesis through its subsidiary, Genesis Global Capital, rose from $500 million in Q4 2018 to $8.4 billion in Q3 2022, a 17-fold increase. As of Q3 2022, Genesis’ outstanding loan amount was $2.8 billion (compared to $123 million in Q4 2018). Regarding on-chain protocols, one of the largest lenders is Aave. Its borrowing amount increased from $124 million in May 2020 to $1.96 billion at the time of The Block’s report release.

To understand the overall growth of the decentralized lending space, the following chart shows the total value locked (TVL) of the largest on-chain lending and collateralized debt position (CDP) protocols.

Twelve protocols including Algofi Lend, B.Protocol, Benqi Lending, Euler, Geist Finance, JustStable, Kava Lend, Liquity, Morpho, Tectonic, Venus, and Vires Finance. The graph provides two insights: first, the decentralized lending space grew from nearly 0 in 2020 to a $18 billion eco in 2022. Second, the severity of the 2022 market downturn is very prominent - it led to a 65% decrease in TVL.

The estimate for the overall size of the digital lending market, defined as the total revenue of all companies providing products and services in the digital lending market, is expected to grow from $10.7 billion in 2021 to $20.5 billion in 2026. This represents an approximate 92% increase, highlighting its future growth potential. In contrast, the global lending market is projected to grow from $7 billion in 2021 to $11.3 billion in 2026, a ‘mere’ 61% increase. However, it’s important to note that these longer-term forecasts were calculated before the recent volatility in the crypto lending space.

Lending needs of financial institutions and professional traders

Among cryptocurrency borrowers, financial institutions and professional traders, especially hedge funds, family offices, and proprietary trading firms, account for the vast majority of cryptocurrency lending demand. For example, the investment strategy of digital asset management company CoinShares includes three main areas of activity, such as market making, statistical arbitrage, fixed income, each with different proportions, and digital asset lending belongs to the latter.

According to market conditions and the company’s investment strategy, a large portion of its book value may be allocated to the lending of digital asset lending companies. Most professional investment methods can be roughly divided into: market making, directional investment strategies, and market-neutral strategies.

GBTC has always been the largest and most popular fund in trading. The reason is that accredited investors can obtain GBTC for Bitcoin at net asset value. After a 6-month waiting period, these GBTC can be sold on the public market at a Secondary Market price. It is worth noting that the fund does not offer redemptions, leading to a significant discrepancy between the stock’s net asset value and the Secondary Market price. Therefore, the fund has traded at a premium to the net asset value for a long time in its history. The premium of GBTC to net asset value is shown in the chart below.

To profit from this premium, hedge funds can borrow Bitcoin and deposit it into Grayscale Trust to receive GBTC based on the net asset value. After 6 months, hedge funds can sell these units on the open market to capture the premium. This trade is not risk-free arbitrage as the premium may disappear before the 6-month holding period ends. This was indeed the case after the popularity of this trade, resulting in a large number of subions, hence the new shares being sold on the secondary market.

Therefore, in February 2021, the premium turned into a discount, with a discount of 40% at the time of writing The Block report. Due to Genesis’s poor financial condition (i.e., suspension of withdrawals) and its relationship with DCG, many investors have sought to reduce their risk exposure to GBTC, thereby increasing the discount. To address these concerns, Grayscale published a blog post outlining why the underlying assets of its trust products (e.g., BTC held in GBTC) are secure, protected, and kept separate from DCG’s other assets.

Digital Asset Lending Situation

The recent collapse of the cryptocurrency market, driven by the bankruptcy protection filings of major participants such as 3AC, Celsius, FTX, and Voyager, as well as the regulatory and market reactions to these developments, has affected the market situation and how participants position themselves within it. However, the ultimate outcome is still unclear. The Block report provides a current snapshot and a brief deion of the current situation, including the companies that have entered bankruptcy protection proceedings and those that have recently defaulted and may be liquidated, as shown in the following figure.

The following chart provides key information about centralized digital asset lending institutions whose funds (in part) come directly from retail investors. Then, depending on the lender’s business model, these funds are either directly invested or lent to retail or institutional clients. Most of these companies are headquartered in the United States (30%), followed by Singapore (28%) and the United Kingdom (17%). Among these companies, larger ones in terms of funds and number of employees tend to be located in the United States, except for Amber Group and Crypto.com which are headquartered in Singapore.

Crypto lending crisis in 2022

First of all, the bankruptcy of many CeFi lending institutions that focus on retail investors has affected the supply in this market. The situation is very uncertain, and even increasing transparency, such as providing proof of reserves, is not a panacea. Unless there are major participants with proper regulation and supervision entering the market, the supply may still be suppressed, at least before the next rise in the crypto market.

Second, the unclear situation of Genesis (including its parent company DCG) may have a significant impact on the overall health of institutional crypto assets. If Genesis defaults, it may lead to a severe downturn in the crypto market again in the short term. Given the importance of Genesis as the core of most yield services and lending activities, the negative impact may persist for some time, including affecting the intermediaries and capital efficiency of the crypto asset eco. At the time of The Block’s report, the future direction of Genesis remains unclear. While centralized lending companies face headwinds, it is still unclear whether on-chain digital asset lending institutions will emerge as clear winners. At first glance, people may draw such a conclusion because their technology naturally has the full transparency of on-chain transactions. However, complete transparency of all transactions may be a warning for some in practice: even if pseudonyms do not specify a clear name for on-chain transactions, competitors may draw conclusions based on publicly visible transaction volume and direction.

In addition, the DeFi crypto eco needs to become more user-friendly to support mainstream lending activities - CeFi platforms offer a more familiar ‘Web2’-like experience at the cost of custodial risk. The recent threat of a potential sell-off spiral in the Solana eco highlights the immaturity, as the Solana eco is touted as the most suitable blockchain for financial institutions, and was caused by a default from a large borrower on its flagship lending protocol, Solend protocol.

Key areas of crypto assets under review by US regulators

Digital asset lending companies are reallocating funds from savers/lenders to investors/borrowers for stable and volatile assets. Although digital asset lending can still be considered niche in terms of the total loan amount globally, the field has been growing significantly in the past few years. Faced with this growth, as well as the recent explosion of the Terra blockchain and the subsequent bankruptcy of major lending companies, US regulatory agencies have increased their focus on the digital asset market. Regulatory scrutiny may focus on three areas: digital asset lending (involving retail investors), stablecoins, and DeFi.

2021 is a record year for the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission’s currency sanctions related to cryptocurrencies. With the continued volatility of cryptocurrencies, enforcement actions and overall reviews have become more intense in 2022. As mentioned above, both federal regulatory agencies claim jurisdiction over crypto assets. Formally, the SEC is responsible for managing securities. Whether digital assets are considered securities is typically determined by the Howey test.

Crypto asset lending is expected to continue to grow in 2023

The recent turbulence in the crypto lending-centered market appears to be a watershed moment, bearing many similarities to the 2008 traditional financial ’s Lehman moment. The Block report suggests that this may have two major implications for the future development of digital asset lending.

First, stakeholders may prioritize transparency. This includes the following:
1, Retail clients who deposit funds for profit.
2, Institutional lenders who may need to ensure the risk of their trading investors.
3, Regulators who need to understand the micro and macro prudent risks of the industry.

Secondly, the impact of cryptocurrency lending defaults on retail clients is the primary concern of regulatory agencies. Under the current rules, regulatory agencies will strengthen the enforcement of regulations on risky cryptocurrency lending for retail investors. At the same time, regulatory agencies are prioritizing the development of regulatory frameworks in this field, including a decentralized scope, mainly targeting institutional clients’ digital assets, and currently lending institutions may not be the primary focus of regulatory agencies. However, given the rapid growth and changes in the regulatory field, it may only be a matter of time before lending institutions receive additional regulatory guidance.

Regulatory Outlook for Crypto Assets

There is basically no regulatory framework for crypto assets, and it has not yet been fully determined which institution is responsible for regulating the digital asset market and companies, such as the Securities and Exchange Commission or the Commodity Futures Trading Commission. In the context of the huge growth and subsequent downturn in the crypto market, lawmakers believe it is necessary to take action quickly.

The regulatory trend is clearly moving towards establishing a comprehensive framework for the operation of cryptocurrency companies. The recent enforcement actions are aimed at cryptocurrency lending institutions that provide investment products to retail clients. Although centralized lending institutions focused on institutional clients are not currently the top priority for regulatory agencies, they may also face stricter regulations, and it’s only a matter of time. The existing regulations on institutions in the traditional financial sector can provide us with insights into the potential leverage that regulatory agencies may use to enforce a fair competitive environment.

Finally, The Block report believes that institutional clients may be a major driving force for future growth, but it just needs a regulatory framework to operate. A large part of on-chain lending is lacking a regulatory framework, which hinders the inflow of capital into the eco. Despite the current severe economic recession, the sector still needs further growth, and the debate between DeFi and CeFi lending has not been resolved. The relative growth of DeFi lending will depend on the continued maturity of on-chain protocols and regulatory clarity.

Disclaimer
Author:
The Block Research
Compiled by Rena W., Gate.io Researcher
*This article represents the author’s views and does not constitute any investment advice.