In our nascent world of decentralized finance, the advent of bitcoin ushered in a new form of value exchange. But for bitcoin to burgeon, it also required the support of a robust lending market. The idea isn’t new; every currency throughout history has thrived with a lending market attached to it. However, despite various attempts, the creation of a concrete bitcoin credit market has often resulted in spectacular failures.
Throughout 2020, we saw an explosive surge in demand for bitcoin and digital asset lending services. Yet, the absence of significant checks and balances in this landscape allowed for reckless operations by unscrupulous players, leading to disastrous outcomes. This unsupervised climate contributed to a wave of collapse within the digital asset lending industry—events highlighted notably in 2022.
The folded lending firms, such as BlockFi, Celsius, and a unit of Genesis, profoundly displayed an inherent flaw. Their operating structures were flawed, devoid of crucial risk “ring-fencing”. Also, the absence of transparency hindered clients’ understanding of their credit underwriting process and the concentration risks involved.
Now, in the world of traditional banking, a non-ring-fenced risk is sustainable only when someone would step in as the lender of last resort—the Federal Reserve, for instance. But for Bitcoin, no such backstop exists. This means the industry must innovate a sustainable model independent of government or state institutions.
Bitcoin lending has indeed blossomed for some. Many investors have enjoyed impressive returns from yield offerings on their digital assets. This was mainly due to lending assets to institutional market makers. These activities also facilitated capital access for market makers in the bitcoin derivatives domain, propelling its growth.
The lending market’s impact traverses even beyond its profit potential. It helps stabilize spot market prices, enables hedges for bitcoin miners, and ensures narrower spreads for bitcoin transactions on global exchanges. But inherent risks must also be addressed.
Remember the collapses of BlockFi, Celsius, and Voyager? These were cases where client assets’ risks were intertwined with the firm’s risky yield products. It signified an immense hazard for the clients, who faced the brunt of bankruptcy when the company’s initiative failed.
To move forward, digital lending platforms need a change. Consider a two-account system—one for safekeeping assets without any risk and another for attempting to generate returns by lending. With this new model, the benefits and risks of lending funds can be “ring-fenced” to the “yield” account.
Transparency also is a driving force in these changes. Be it in the form of easy-to-read reports or diversified lending, investment platforms are gearing up to offer more transparent services. It is a crucial step towards a more reliable and mature digital asset lending ecosystem. It’s time to bid farewell to the “Wild West” phase of digital asset lending and welcome the era of Enlightenment.
Source: Coindesk
