This article was kindly contributed by Guest Author, Jonathan Wai.
In this series of articles, we take a deep dive into the world of DeFi and explore yield farming strategies.
“Yield farming” involves doing more than just holding the asset alone. The simplest and most popular methods are lending, staking, and providing liquidity. Lending of crypto assets is the most straightforward of the three, and will be the focus of this article.
Risks of Crypto-Lending
Given that the model of crypto-lending is largely similar to that in traditional finance, its risks are relatively straightforward to analyse.
Credit risk
Investors should start by assessing the risk of the crypto-lending service used as well as the borrower’s credit risk.
With most crypto-loans being heavily over-collateralised, credit risk is significantly mitigated but the tail risk of a flash crash remains, which would result in a significant loss of value of the posted collateral. This is why crypto-lending services usually require collateral to be posted in well-known crypto-assets like BTC or ETH.
Investors should carefully consider the lending model and assess their comfort with key metrics like the assets accepted as collateral, LTV and liquidation thresholds, and for uncollateralised loans, how the service assesses borrowers’ credit quality.
While interest rates are often a good indicator of credit risk in traditional finance, it is impossible to compare the risk between different crypto-lending services or borrowers by interest rate alone due to significant market inefficiencies.
Factors that contribute to this include the lack of rating agencies for institutions and standardised credit assessments for individual borrowers, the multitude of crypto assets, services, and functions available, and asymmetric information arising from the decentralised nature of the crypto market.
Together, these lead to inefficiencies in DeFi that cannot profitably be exploited with arbitrage. Investors who spend time doing due diligence may be able to profit from these differences, but should remain wary of hidden risks.
Market risk
Investors should also consider the risk associated with holding crypto assets.
As deposits are denominated in a certain crypto asset, investors run the risk of the price of that asset falling significantly. Crypto assets are known for their volatility, and investors should not deposit or lend any crypto assets that they would not otherwise be comfortable holding. While this risk may be somewhat mitigated through the use of stablecoins, there remains forex risk as such coins are pegged to the US Dollar.
There are also different mechanisms that aim to maintain the peg of such stablecoins, and investors should be aware of these differences and the risk that their peg to the US Dollar fails.
As explained above, the risk of large adverse price movements also results in liquidity risk where loan collateral cannot be liquidated without incurring substantial losses.
Smart contracts risk
Many crypto-lending services rely on smart contracts to execute transactions.
Smart contracts are programmable contracts that reside on the blockchain and perform functions, such as executing transactions, without direct human intervention. Investors should be aware of the risk that such smart contracts may fail to perform as expected due to bugs or improper programming, and can also be subject to hacks by external parties. There is a real risk that deposits could be lost to smart contract failures.
In addition, the immutable nature of the blockchain means that erroneous transactions cannot be reversed.
Counterparty risk
When dealing with centralised platforms offering crypto-lending services, investors should consider the security and credibility of the service provider. While well-established service providers may be more reliable in that they are unlikely to disappear with deposits, they are still subject to hacks and smart contract errors.
Often, crypto-lending services hold their crypto assets in “cold” rather than “hot” wallets, reducing the risk that the assets are lost through a hack. Investors should consider the security features that crypto-lending services employ to safeguard deposits and collateral.
The best crypto-lending services also offer customer support where depositors can contact staff directly to ask questions and resolve issues. Having customer support that is responsive and friendly shows that a service is genuine about alleviating concerns and protecting depositors.
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Legal risk
Investors familiar with DeFi will be aware that it remains a largely unregulated space. As regulators around the world embrace the emergence of DeFi, there remains the risk that crypto-related services become outlawed or otherwise impractical to use in certain jurisdictions.
When sudden changes in laws or regulation prevent a service from operating, investors may find themselves being unable to access or transact in their crypto assets. This is especially concerning if assets are locked up in a loan and cannot be dealt with immediately.
Investors should also take time to read the terms and conditions governing crypto-lending services. While most services accept credit risk on depositors’ behalf, there remain a handful of crypto-lending services that transfer credit risk directly to the depositor.
Where an investor is a depositor, the crypto-lending service pays the depositor interest in exchange for making the deposit and takes on the risk of non-performing loans. However, when the borrower’s credit risk is transferred to the investor, the investor effectively becomes the lender directly transacting with the borrower and assumes fully the risk of the loan. In cases where such loans are un- or inadequately collateralised, the investor could face significant losses in the event of default.
Risk Mitigation
After understanding the risks involved in crypto-lending, investors can also think about how to mitigate these risks.
Hedging with derivatives
Much like in traditional finance, price volatility of crypto assets can be hedged using derivatives.
While this may be of limited application should the deposited crypto asset be a stablecoin, investors can also mitigate stablecoin-related risks with insurance. Nevertheless, options and other derivatives remain a good choice for investors seeking downside protection for their crypto assets or to remain delta neutral.
Licensing, regulation, and audits
Centralised crypto-lending services (ie those that operate through a traditional corporate structure and not a DAO model) may be required to be licensed under each jurisdiction’s relevant laws and regulations.
While obtaining licenses does not guarantee the security of deposited funds, it can give investors peace of mind that a certain level of compliance with financial regulation is assured.
There are also auditing services that verify the claims and audit the technical infrastructure of crypto services. While this does not mean the service is risk-free, investors can find some comfort in regular audits by established services and have an additional measure of assurance that crypto-lending services are legitimate.
Insurance
Investors should also note that stablecoin deposits placed with crypto-lending services are not covered under any government-linked deposit insurance schemes.
However, many crypto-lending services have partnered with third-party DeFi insurance providers to offer insurance on deposits.
Presently, insurance policies are available that cover hacking, smart contract related risks, and stablecoins that de-peg from their fiat counterparts. Investors should examine each individual policy carefully to see what events are covered and consider the reliability of insurance providers to decide if the premiums for such insurance, which can be substantial, are worth the risks involved.
What’s Next?
While the DeFi space is rapidly growing with institutional investors beginning to take notice, its decentralised nature means it is still very much an unregulated wilderness and investors should be aware of the dangers that lurk within.
While we are unlikely to see regulation of DeFi by traditional regulators in the near future, the influx of institutional capital is leading to increased investor confidence and potentially new markets for derivative services like deposit insurance.
The coming years will tell if the pioneers in the crypto-lending space have the capacity to scale, and whether the world of decentralised finance can mature enough to complement the existing financial system.
In the meantime, the lending of crypto-assets can be a highly lucrative endeavour for savvy investors seeking returns – provided risks are managed well.
This article was kindly contributed by Guest Author, Jonathan Wai.
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