Downstream Impacts Of The Recent Market Crash On Lending, Stablecoins, And DeFi

Lending Markets: Behind the Scenes on What Drives Rates

The crypto lending markets have seen strong traction, with an estimated $13 billion in total loan originations over the past several years from both traditional institutions and crypto-native offerings.

For context, lending markets enable participants to:

  • Lend their crypto to others and receive interest rate payments.
  • Borrow crypto against posted collateral for an interest rate fee.

These markets are either offered through central intermediaries or smart contract platforms that seek to ensure against a loss of funds. The primary revenue stream for companies in this space is Net-Interest Margin, where players capture a spread between the interest rate offered to borrowers and the interest paid out to lenders.

But lending activity comes with risk. Borrowers can default on loans, especially when the underlying collateral (crypto) experiences significant volatility. In this piece, we examine how lending markets behaved in the recent crypto crash on March 12. But before diving in, we first need to understand the mechanics behind what drives interest rates, and how this is tied to market conditions.

Why do people take out loans?

Borrowers post some form of collateral and borrow either crypto or cash for:

  1. Speculation — Going long or short crypto by either borrowing crypto and selling for cash (going short), or borrowing cash and buying crypto (going long). Both are important mechanics for investors to amplify return and/or hedge risk, especially during high volatility periods.
  2. Working Capital — Liquidity to fund business endeavors or personal matters. Bitcoin as working capital is important for several businesses (e.g., miners, OTC desks, remittance, prop trading firms, etc) who require access to significant capital to facilitate operations. Moreover, borrowing is typically not a taxable event, and thus is an opportunity to keep exposure to crypto without incurring tax penalties.
  3. Derivatives arbitrage.

Derivatives arbitrage requires a deeper explanation. Take Bitcoin futures contracts as an example. These contracts are agreements to buy or sell Bitcoin at a specific price at some point in the future, and how these markets are priced reveal investor sentiment. Typically, BTC futures markets are bullish, where the price to buy or sell a Bitcoin three months in the future is higher than the spot price today.

The difference between the spot price and the futures price represents an opportunity for arbitrage through a cash-and-carry trade. If the three-month BTC futures price is 5% higher than today’s spot price, a savvy investor can borrow cash to purchase BTC today, and simultaneously go short on the Futures market (locking in their sale price in three-months at the 5% premium), effectively capturing a 20% APY over the next three months.

If the interest rate charged on borrowing cash over three-months is less than 20% APR (and any additional fees), you profit on the difference.

Crypto market sentiment is usually net-bullish. The average volume on Coinbase Consumer is 60% buys, borrow demand is net-long from leveraged long traders, and the futures curves are typically bullish. This sentiment drives cash borrow demand, but what happens when the market turns bearish?

For one, the cash-and-carry trade turns to a crypto-and-carry trade, where you would borrow BTC instead of cash to capture the Futures arbitrage, and immediately sell on the spot market and go long on the Futures contract.

When futures curves turn bearish, lending markets flip to crypto-borrow, and cash borrow demand dries up.

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