Continuous Explosions of Funding Pools: Reflections on the CEFI Crypto Lending Market Model

Author: David, W3.Hitchhiker

1. What is Crypto Lending

Cryptocurrency lending is an innovative financial tool that allows for quick access to liquidity by using cryptocurrencies as collateral to obtain loans. Platforms that offer crypto lending typically also provide deposit services, where depositors earn interest by depositing cryptocurrencies into accounts. These platforms attract crypto deposits by offering deposit interest rates that are higher than market rates (generally annualized rates of 4 - 12%).

Crypto lending platforms usually lend to institutions or individuals in an over-collateralized manner while also engaging in over-collateralized lending in the OTC market to participants in crypto trading, such as exchanges, market makers, or hedge funds, who require immediate financing (for leveraged trading or short selling, etc.).

Crypto lending does not require a credit investigation of the borrower (though it may involve varying degrees of identity verification and source of funds checks), but borrowers must pledge cryptocurrencies to lenders, who typically deposit the collateral into a custodial account upon receipt. This differs from P2P lending, which generally involves unsecured loans for specific projects and does not typically involve collateral.

2. Overview of Centralized Crypto Lending Markets

In 2020 alone, the managed assets of the three major CeFi lending platforms grew by 734%. Celsius and BlockFi each hold over $4 billion in assets, while Nexo's managed assets are approximately $2 billion. The total assets locked on these three CeFi platforms amount to nearly $7 billion.

3. The Role of Crypto Lending

Facilitating Market Arbitrage:

Cryptocurrencies remain an emerging asset class with low market liquidity, leading to high price volatility. The lack of liquidity often creates arbitrage opportunities; for example, if different cryptocurrency exchanges have varying levels of liquidity, there will be different trading prices at the same time.

Crypto lending provides liquidity to institutional investors such as hedge funds, crypto exchanges, or market makers, enabling them to capitalize on these arbitrage opportunities. The more market participants engage in arbitrage trading, the smaller these opportunities become, making the entire crypto market more efficient and stable.

Providing Liquidity to Crypto Institutions:

Due to relatively lagging regulations, institutions involved in crypto activities, such as miners or crypto investment firms, often struggle to obtain liquidity through traditional financial systems, with many unable to open bank accounts. They typically rely on crypto lending to access liquidity.

As cryptocurrencies gradually gain regulatory recognition and their value is legally established, the application scenarios for crypto lending are bound to expand. Entering 2022, more and more CeFi or traditional financial institutions began accepting BTC as collateral for margin loans, such as the $250 million loan from Silvergate Bank to MicroStrategy. However, overall, the window for crypto institutions to obtain USD liquidity remains narrow.

Improving the Efficiency and Inclusiveness of Financial Resources:

Due to the technological nature of crypto lending and the digital attributes of collateral, multiple transactions and rapid processing can be achieved in a short time, offering significant efficiency advantages over traditional financial institutions. Additionally, on-chain crypto lending eliminates the need for credit assessments of borrowers, focusing on the asset rather than the individual, thus enhancing the inclusiveness of financial services.

4. General Terms of Crypto Lending and Current Situation of CeFi

By reviewing the general terms and conditions of crypto loans on platforms like NEXO and BlockFi, the following characteristics can be observed:

1. The value of loans is determined based on the LTV (Loan-to-Value) provided by the platform. The value of the collateral is calculated by the platform based on market prices and relevant policies.

2. The platform retains ownership and all associated rights to the collateral during the period of the relevant loan, and can decide to dispose of the collateral in any manner. This point is somewhat controversial, as in typical mortgage rights and obligations, the lender only obtains a security interest rather than ownership of the collateral, and the security interest is generally subordinate to the debt.

3. If the LTV increases beyond the maximum allowable value, the platform should liquidate the necessary amount of collateral to bring the LTV back to normal levels after notifying the customer as early as possible. Due to the volatility of the digital asset market, customers need to be aware that they may not be technically notified in advance before relevant liquidations, and they are fully responsible for monitoring the current market conditions and maintaining the collateral ratio at normal levels at any given time.

4. Regarding the determination of LTV, as of July 4, 2022, NEXO and BlockFi's websites display the following:

5. The calculation of crypto loans is based on compound interest.

According to the SEC's investigation of BlockFi in February 2022, since the launch of BlockFi's interest account service BIA on March 4, 2019, BlockFi has claimed in its website and various promotional materials that its institutional loans are "typically" over-collateralized, with an LTV of less than 50%.

In reality, most institutional loans have an LTV that exceeds this figure, as institutional investors are generally unwilling to provide over-collateralization, and competition in the lending market often forces platforms to relax collateral requirements to gain business. According to SEC investigation data, approximately 24% of institutional crypto asset loans were over-collateralized in 2019; only about 16% were over-collateralized in 2020; and about 17% were over-collateralized in the first half of 2021.

In practice, the collateral ratios are much higher than required, leading to a significant increase in the risk level of the entire lending asset: even slight fluctuations in the price of collateral can expose the entire asset to liquidity risk. This arrangement also places more risk on individual investors.

5. General Terms of Crypto Deposits and Current Situation of CeFi

By reviewing the deposit terms of relevant platforms, the following characteristics can be observed:

1. Users can choose between fixed-term and flexible-term deposits. Fixed-term deposits can become additional collateral when LTV is insufficient. Interest can be paid in the deposit currency (compound interest) or in platform tokens (simple interest), and users can switch between the two (using NEXO as an example). If users choose platform tokens as interest earnings, the platform offers additional interest as an incentive. Users can deposit or redeem products at any time. Generally, similar platforms attract customers with high yields (as shown in the image below). This image was taken on July 4, 2022, and despite numerous platform failures, NEXO still promotes this high-yield gimmick on its official website.

2. BlockFi also explicitly states in its deposit account terms that it is not responsible for any loss of funds due to cyberattacks or technical issues. Such disclaimers seem somewhat strange for a company that claims to operate in technology.

3. Based on the characteristics of the deposit accounts, which are investment contracts sold to the public that can yield expected monetary returns, the SEC issued a regulatory letter to BlockFi on February 14, 2022, stating that its deposit accounts essentially qualify as securities. BLOCKFI currently clarifies in the notes section of its website that BIA does not belong to bank or securities accounts and therefore is not subject to regulatory protection.

4. Since March 4, 2019, BlockFi has provided and sold BlockFi account BIA to investors, allowing them to lend crypto assets to BlockFi in exchange for promised interest earnings. According to the SEC, BlockFi "bragged" in advertisements that BIA balances of up to 25 BTC or 500 ETH (which were approximately $100,000 and $70,000 at the time) would earn an annualized return of 6.2%, while all balances exceeding that limit would earn a tiered interest rate of 2.0%. However, SEC evidence revealed that as of November 1, 2021, the actual interest rates paid to investors by BlockFi ranged from 0.1% to 9.5%, depending on the type of crypto asset and the investment size. The benefit for depositors is that they can redeem their deposits at any time.

6. Is it a Ponzi Scheme?

The current CeFi model can be simply likened to a Ponzi scheme. A Ponzi scheme is a long-standing non-compliant financial operation familiar to domestic investors, which illegally absorbs funds through high-interest deposits. On the asset side, it utilizes the opaque nature of the asset pool to shuffle assets internally, artificially matching risks and returns, leading to significant systemic financial risks.

According to domestic financial regulatory documents, a wealth management pool can be defined as "non-compliant fund pool operations refer to multiple wealth management products of different types and durations corresponding to multiple assets simultaneously, making it impossible to achieve separate accounting and standardized management for each wealth management product."

Such fund pool operations generally continue to raise funds by rolling out various wealth management products of different durations to maintain a balance between funding sources and uses, with investments directed towards various assets including bonds, notes, and trust plans. Fund pool wealth management products typically feature "continuous issuance, collective operation, maturity mismatch, and separated pricing." To ensure smooth fundraising, fund pools often exhibit characteristics of high-interest deposits.

• Continuous Issuance and High-Interest Deposits: Continuous issuance refers to the ongoing issuance of wealth management products for fundraising. From the terms of most CeFi platforms' deposit accounts, users can deposit or redeem tokens at any time, and some even allow changes to the interest calculation method at any time. As mentioned earlier, most platforms attract investors with high yields.
• Collective Operation: Collective operation refers to the pooling and management of raised funds, uniformly applied to various target assets that fall within the investment scope of the asset pool, with the operational returns of that asset package serving as the unified source for determining the returns of each product. According to SEC investigations, BlockFi raised funds by opening BIA accounts for investors in exchange for crypto asset investments. BlockFi pooled the crypto assets of BIA investors and used these assets for lending and investment, sharing investment returns and interest earnings with BlockFi and BIA investors. According to investigations by the Texas Securities Association, Celsius similarly "freely uses the cryptocurrencies deposited by investors in interest-bearing accounts, mixing coins from various sources, investing in traditional financial assets and crypto assets, lending to institutional and corporate borrowers, and engaging in any other activities determined by Celsius." The main issue with collective operation is the lack of transparency, which provides a stage for high-risk operations and benefit transfers.
• Maturity Mismatch: Maturity mismatch refers to the differing terms of the funding sources for the asset pool and the terms of the asset package. Maturity mismatch, especially the long-term nature of the asset side combined with the short-term nature of the liabilities, makes it easy for institutions to experience a run, leading to market panic, forcing platforms to announce withdrawal freezes. The following image shows market rumors that BlockFi engaged in long-term (3-year) borrowing at a very high LTV.

Celsius's investments in stETH and WBTC, as well as Three Arrows Capital's investments in Grayscale Trust shares, and similar asset pool investments in the primary market, exemplify liquidity crises caused by maturity mismatches. Most of the funds raised by CeFi platforms are of a flexible nature, redeemable at any time, while their investments are long-term.

• Separated Pricing: Separated pricing refers to the yield levels of various wealth management products issued from the same asset pool, which are generally not directly tied to the actual returns of the collective asset package during the product's duration but are priced based on the expected yield of the collective asset package. This pricing method can lead to a mismatch between the actual risks and returns for customers and BlockFi. The following image is an example from Bitconnect, where the more funds users deposit, the higher the "guaranteed" interest rate and the shorter the payback period, with the interest rate not linked to the actual returns of the underlying assets.

Separated pricing also leads to insufficient risk pricing, creating a so-called "death spiral" in down markets. Institutions, having promised high returns, are forced to invest in higher-yielding investments, similar to the market's sharp cooling towards high-risk crypto projects after the Luna collapse, leading Celsius to face redemption pressure. As of May 17, the value of assets locked on the Celsius platform plummeted from over $28 billion at the end of December to less than $12 billion. In the context of overall shrinking DeFi yields, to meet the promised 17% returns to customers, Celsius had to take risks and engage in high-risk operations.

The result is that Celsius participated in several high-risk projects using customer tokens, leading to consecutive failures:

• Lost $120 million in the BadgerDAO hack last December;
• Withdrew $500 million in UST from Anchor during the Luna incident (avoiding losses);
• The imbalance in the stETH/ETH pool could also expose the company to liquidity risks.

Especially when the overall crypto market declines and customers rush to redeem BTC or ETH, discovering that the company has suspended withdrawal and transfer functions exacerbates panic.

It is evident that the currently troubled crypto lending platforms exhibit all four characteristics mentioned above, making them typical Ponzi schemes.

7. Is DeFi Superior to CeFi?

Currently, it appears that without effective regulation, the operations of CeFi inherit the Ponzi scheme model from traditional finance, becoming a breeding ground for non-compliant financial operations, posing a significant threat to the further development of the crypto ecosystem.

So, will DeFi improve the situation in addressing these issues? The answer is affirmative. DeFi's smart contracts effectively address the opacity of the asset side and the counterparty risk (de-trustification) issues during actual execution, significantly mitigating the accumulation of financial risks.

However, it remains to be seen whether effective risk pricing will ultimately emerge from the collective operation of funds, as no projects have yet provided solutions to this issue.

8. So, has the crisis ended?

On June 29, Three Arrows Capital announced bankruptcy liquidation. Three Arrows Capital is currently one of the largest lenders and clients in the global crypto lending market, and almost all institutions in the image have business dealings with Three Arrows (except for NEXO and CoinLoan, which have already claimed they have no exposure to Three Arrows). The bankruptcy liquidation of Three Arrows will have a chain reaction on the market, forcing many institutions to bear losses, write down their balance sheets, and even apply for bankruptcy directly.

On July 6, Voyager Digital, which has 3.5 million users, announced bankruptcy, managing $5.8 billion in assets. Further liquidation actions in the crypto market are likely to occur.