A specific structural problem has developed in the bitcoin lending market. DeFi yields have fallen as fewer participants borrow for leverage, while a wave of new lenders from both traditional finance and DeFi has pushed capital supply higher. The math does not work.
Two Prime, as one of the largest BTC-backed lenders in the world, has a front-line view of how this dynamic is developing. This article explains the mechanics of the mismatch and what it is likely to produce for lenders, borrowers, and the broader market.
Alexander S. Blume
Co-Founder and CEO of Two Prime
What Is Happening in Bitcoin Lending
As one of the largest BTC-backed lenders in the world, Two Prime has a view on the front lines of how the industry’s lending markets are evolving. A unique dynamic has emerged over the past six months that may lead to significant problems. After the October 10th washout across most alt-coins, DeFi yields have fallen precipitously. Fewer participants are willing to borrow at high rate for leverage. At the same time, a large wave of new lending participants also joined the market, looking to lend against overcollateralized collateral like BTC or other altcoins. This is coming from both TradFi participants like JP Morgan, as well as new DeFi entrants. As a consequence, borrowing demand has gone down at the same time that rates have fallen. This creates pressure on firms to win loans and take extra risk. What we are seeing emerge is a mismatch in terms between capital sources and borrowers. This runs a high risk of ultimately causing significant damage to the market due to lender insolvency.
The Capital Mismatch
The current market places lenders in a difficult position. On one hand, stable capital sources are slowly coming from major wall street financial institutions. This comes with months of diligence, hundreds of questions to answer, and higher rates. On the other hand, cheap capital awaits today on-chain. It comes with few questions and very low rates, but it can leave at almost any time and has no loyalty or relationship behind it.
How Mismatches Lead to Blowups
The biggest key to not blowing up your lending book is to avoid mismatches on duration, term, and rate. For example, if you have a capital source that can call their money back with one day's notice, but you lend money out for a year, you can very quickly go bankrupt. This even happens to banks at times, when unexpected “runs” on the bank occur, and they are stuck with long-duration instruments trading at a discount to par. Unfortunately, this is exactly what is happening in the crypto lending market today. The best and largest borrowers want longer-term duration loans with fixed rates. However, the majority of capital available in DeFi is floating-rate and open-term. Since DeFi is currently very depressed, capital is willing to accept rates of 3-5% on their dollars, but a surge in the BTC price will likely raise prices across the industry,l prompting capital providers to pull funds quickly to rotate into more lucrative opportunities. There will be lenders caught in the middle, with much more lax policies than banks and, consequently, insufficient capital to meet these redemptions. Further, the “looping” employed by many traders, effectively taking borrowed capital and lending it out again to achieve higher rates still, means that unknown amounts of leverage are built into DeFi markets. In the institutional space, like banks, these risks are slower-moving and can be managed more calmly. In DeFi, these risks stem from supply and demand dynamics. Changes to rates and redemptions can occur quickly when the market moves sharply.
Who Gets Hurt
This can happen quite suddenly and with serious consequences. A group with an insufficient balance sheet will not be able to manage redemptions, and either capital providers will suffer losses, or they will have to sell the borrower's collateral to meet those redemptions. Increasingly, even traditional institutions are seeking out funding from these DeFi markets. They may not even know it, since a middle-man may stand in the middle and not disclose the duration or rates behind the capital they garner. This means that end borrowers could be significant institutions that experience the brunt of this. This can end in cascading bankruptcies and lawsuits, akin to the FTX, BlockFi, and Three Arrows Capital mess we saw in 2021/2022. As rates go up, we may see lending groups shift funding away from open-term, open-rate DeFi sources that suddenly become expensive and towards more stable sources. Some may not succeed in time or may be unable to access new funds. This can become a chicken-and-egg problem, where the collateral they need to find new capital to pay off one capital source is locked into an existing loan already.
This problem has arisen in traditional markets throughout history, which is why the Office of the Comptroller of the Currency and legislation such as Basel II and Basel III have strict rules governing how banks support the deposits they hold. No such rules exist at DeFi firms, and market pressures are pushing decision-making further down the risk curve. I hope that I am wrong, but I worry a serious blow-up is on the horizon. And it could happen just as bitcoin gets its footing back.
This article originally appeared in Forbes.