Loans are as old as money. Throughout history - from seeds to gold, every form of money has had a thriving lending market. Bitcoin is a digital, more transparent asset - and for it to thrive, it will also need a lending market.
The demand for bitcoin and digital asset lending services became evident during the 2020 runup, when tens of billions of client assets flowed to centralized and decentralized lending platforms. An environment of easy money policies and supersonic growth allowed bad actors to act recklessly and mislead consumers, without any checks and balances. All of this ultimately led to the “Sam-tastic” collapse of the digital asset lending industry in 2022.
Although fraud is nothing new, the sudden domino-like collapse of dozens of digital asset lending firms was caused by yet another problem: the operating structure most players were using was unsustainable. There was no ring-fencing of lending risk, and there was no transparency from lenders that allowed clients to gain visibility into their process of credit underwriting, or the concentration risks in their lending activities. The legacy structure, plus absent risk management was a forest fire waiting for a spark. Terra/Luna, 3AC and FTX did just that.
When we designed our risk management policies internally, we thought through what financial and due diligence requirements to put in place to screen borrowers, the appropriate lending parameters for the type of borrower and finally, how to protect Ledn and its clients in the event that these checks and balances fail. These tight risk management policies allowed us to navigate the 2022 storm without losing a cent or satoshi of our clients’ assets. Even still, we learned a lot from the 2022 events, and went straight to work in upgrading every aspect of our business.
History shows that a lending structure with no ring-fencing of risks only works when there is a lender of last resort. This is why banks need a Federal Reserve. That doesn’t exist in bitcoin, the industry needs a new model - one that doesn’t require government or state institutions as a backstop. We believe our new Growth Account model can be the blueprint to rebuild a digital asset savings experience in a sustainable and responsible way.
The case for a bitcoin lending market
Many people have been able to earn a great return on their bitcoin and digital assets by using yield offerings. These services allow digital asset holders to earn passive income, just like investors in traditional finance do. That yield is enabled primarily by lending those assets to institutional market markets.
Bitcoin lending markets have enabled access to capital for market makers to participate in the bitcoin derivatives markets (futures and options), and help those markets flourish. This, in turn, has crushed down bitcoin price volatility, and has made bitcoin prices more stable over time.
Market-makers have also thrived in arbitraging price discrepancies across different exchanges, in doing so, they’ve obliterated the bid-ask spread across exchanges over time, to the benefit of consumers. This means bitcoiners get more dollars when they sell and more bitcoin when they buy.
The lending market is like the oil that keeps financial markets running smoothly - it not only facilitates faster settlement across entities, but a host of other functions. Bitcoin lending markets enable: options for bitcoiners to earn yield; tighter spreads to buy and sell bitcoin on global exchanges; more price stability for bitcoin spot markets; a healthy spot short market for honest actors to hedge their positions in a tax-efficient manner; and a more efficient bitcoin derivatives market for miners to hedge their production - just to name a few.
How to offer yield responsibly
Based on our learnings, we resolved to rebuild our savings experience around the pillars of trust, risk mitigation, transparency, access, and client control. We believe that Ledn’s new Growth Account structure addresses many of the systemic risks that became evident during the 2022 events. These include:
1) Ring-fencing of individual product risk
Previously, when you interacted with a company’s service - say, a bitcoin-backed loan, you were automatically commingled with the risks of their yield products. Meaning, that if the company went bankrupt because of a loan impairment in their “yield” program, your bitcoin-backed loan would have gone down with it, and you’d be stuck in a multi-year claim to maybe see some of your bitcoin collateral back one day. This is what happened at BlockFi, Celsius, Voyager and others.
Under the new Growth Account model, Ledn clients are now able to choose between holding assets in a “Transaction Account” which does not earn yield, but where assets are mostly sitting in cold storage; or they can opt into the “Growth Account'', which does earn yield and where they will only be exposed to the benefits and risks of loans issued out of the Growth Account pool of assets. That means Growth Account clients are not exposed to Ledn bankruptcy risk, and Transaction Account clients are not exposed to the risk of an institutional loan impairment issued from the Growth Account. Loans issued from the Growth Account continue to be underwritten applying Ledn’s strict risk management acumen, with even tighter covenants imposed on our institutional borrowers.
The new structure minimizes the probabilities of an all-or-nothing outcome for all Ledn clients. In the event of a loan impairment in an institutional loan from the Growth Account, a recovery process begins. If a loan representing 10% of the Growth Account asset pool is impaired, 10% of the Growth Account client’s balance will be locked and sent to a “Loan Recovery Pool”. The remaining 90% of unimpaired assets will continue earning interest, and will be available for withdrawal should clients choose to do so by moving such assets from their Growth Account to their Transaction Account. Any assets recovered from the impaired loan will be returned back to the client’s Growth Account. No more waiting for messy bankruptcy processes with all of your assets tied up.
2) Visibility around concentration risk in lending counterparties
When you lure billions of dollars from people into your platform under the promise of paying high yields, and there’s only one institution willing to take assets and pay those rates, you have 2 choices: you either stop lending to that institution beyond what you’re comfortable with, and lower the rates you offer to clients; or you continue lending to that institution and lend amounts way above what you can comfortably tolerate. Lending within a tolerable threshold means managing concentration risk, and it's a base pillar of risk management.
If clients could have seen how much was being lent to one counterparty - regardless of the name, they could have made different decisions. At the time of its bankruptcy filing, Voyager had 58% of its loan portfolio outstanding to one counterparty - 3 Arrows Capital. Other firms had similar concentrations with Genesis and/or Alameda. For further context, as far as we know, 3 Arrows did not supply financial statements to lenders, which is an absolute necessity in order to properly assess the financial health of an organization BEFORE agreeing to lend to them.
We wanted to address this risk head-on, so we introduced our Open Book Reports, where we outline the utilization of our assets in order to generate yield, and finance our bitcoin-backed loan operations. We break down the Growth Account loans by institution, and show what percentage each one has. The reports are currently produced once a month, and we’re working to provide updates in real time, right on our clients’ dashboard.
Concentration risk is also an integral part of our credit underwriting policy. We limit the amount any one entity can borrow to a maximum of 30% of the Growth Account assets. With the Open Book report, clients can monitor the utilization and concentration of our Growth Account assets, and make more informed decisions.
Building a better future
If the Open Book report was an industry standard, clients from the now-bankrupt companies could have seen the levels of concentration some lenders were operating with, and decided to withdraw proactively. It could have saved thousands of people and millions of dollars.
If the Growth Account model had been an industry standard, clients from the now-bankrupt companies would have a considerable amount of their assets today. The impaired portion would be tied up in a recovery process, but having a good chunk of your assets vs. none is a materially better outcome.
If the Growth Account model had been an industry standard, clients with bitcoin-backed loans at the now-bankrupt companies would not have been affected.
The new structure creates a much better experience for clients - one where they are informed to make better decisions, have more options to choose from, and where the risks and benefits of a particular service are distributed among the clients that chose to participate in it.
Bitcoin is maturing, and so are its lending markets. This new structure is a time-tested solution to an old problem - in a modern asset class. It will be a solid and sustainable foundation over which a thriving lending ecosystem can be built.
The future looks bright.
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