Lending markets: behind the scenes on what drives rates
The crypto lending markets have seen strong traction, with an estimated $13B 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:
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.
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.
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 3 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 3-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 3-months at the 5% premium), effectively capturing a 20% APY over the next three months. If the interest rate charged on borrowing cash over 3-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.
Given the volume in derivatives markets (often > $5 B / day) and sometimes substantial differences between futures and spot prices, derivatives arbitrage is typically a significant source of borrow demand.
What drives rates? Why are DeFi interest rates typically so high?
Like any market, rates are ultimately a function of supply and demand, but there are deeper mechanics at play:
Crypto lending markets accept crypto as collateral…: For many crypto institutions and individuals, their deepest pool of capital is crypto, and this is the only viable path to collateralizing loans.
… And using crypto as collateral is generally higher-risk: Crypto is more volatile making it more difficult to fit into lending risk models. This both restricts the number of companies who accept crypto as collateral (diminished supply), and they demand a higher interest rate to account for the risk.
Stablecoins are preferred over cash due to increased efficiency: It takes time to upload cash into crypto. Many borrow use-cases require immediate action, and thus restrict options to crypto-native solutions where stablecoins are ready to deploy. This increases demand for stablecoins.
DeFi Lending desks are still niche and challenging to access…: Only those deeply involved know how to access DeFi services like Compound and think through the risks. This will change, but it still restricts supply today.
… and carry smart contract risk: DeFi platforms are a collection of smart contracts and potentially vulnerable to exploits. More risk demands a higher interest rate.
Collectively these effects result in typically higher stablecoin and crypto borrow/lend rates, especially in DeFi.
We expect these rates to ultimately compress over time as crypto adoption grows. More lending desks will accept crypto as collateral, stablecoins will grow in adoption, crypto to fiat bridges will be more efficient, and DeFi will become more mainstream and have better protections against smart contract risk. Until then, we can enjoy higher APY on stablecoin lending rates on places like Compound, Dharma, and Dy/Dx.
What happened when the markets crashed, and what should we expect in the future?
The status quo is heavy stablecoin borrow demand from speculation, working capital, and derivatives arbitrage. But when market sentiment flips:
Borrowing crypto increases: In order to hedge risk (going short)
Borrowing cash to go long decreases amidst increased risk: Even if you believe markets will go up in the long-term, significant volatility can quickly wipe out your position
Futures curve turns bearish: Flipping stablecoin demand to crypto demand
Compound’s Lending rates shows the magnitude of this switch:
As market sentiment returns to bullish and volatility decreases, we should expect stablecoin borrow demand to rise, likely to previous levels. This will be an important development, as many crypto companies rely on high stablecoin APY rates to subsidize growth. These are crypto neo-banks like Dharma, Linen, and Multis.
Overall, crypto borrow/lend is a significant business today, and likely to grow in the future. Market sentiment specifies demand preference, but overall demand remains high in both bullish and bearish markets. Coinbase will look to expand borrow / lend services where possible with the goal of increasing borrow / lend liquidity and helping the crypto market mature.