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Understanding the risks posed by crypto lending platforms

06:56, 21 June 2022

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Website of SALT, a blockchain cryptocurrency lending platform.
Understanding the risks posed by crypto lending platforms - Photo: Shutterstock

The sense of chaos gripping the crypto lending sector increased over the weekend on media reports that (DeFi) platform MakerDAO ( decentralized autonomous organization) prevented the DAI stablecoin from being minted and deposited on the AAVE blockchain

MakerDao’s move came on concern at AAVE’s exposure to an ETH derivative, known as stakedETH (stETH) but forced liquidations on crypto platforms are cratering BTC and altcoin prices alike 

DAI to US dollar

MakerDAO's travails follow Celcius Network suspending withdrawals, again sparked by its exposure to stETH, a digital token which will only vest once ETH next’s hard fork, known as the Merge, happens.  

CEL’s native token has taken a battering as a result and the loss of confidence in seETH is in turn a function of the collapse of the Terra Network algorithmic stablecoin UST

This crypto death spiral has driven BTC and ETH prices down to levels not seen since November 2020, and while both are staging a minor comeback at the time of writing conditions in the crypto market remain fraught.

BTC to US dollar 

The current wave of FUD rolling over the digital asset market is largely due to crypto lending platforms, so how do they work and how many of them are there and what risks do they pose? 

How many crypto lending platforms are there? 

It is tricky to place an exact value on crypto lending, although data from DefiLlama in early June suggests there are around 140 protocols providing crypto loan-based services with a cumulative total value locked or TVL in excess of $50 billion.

While these figures suggest an abundance of choice, Ethereum is the dominant blockchain due to liquidity levels that dwarf those of other chains. 

Ethereum to US dollar 

“The largest platforms such as Compound, Maker, Aave, and Iron Bank are the most popular given their large presence on Ethereum mainnet as well as their relative longevity compared to other lending protocols,” says ‘Puff’, a lead contributor at decentralized lending platform Iron Bank.

Tarun Gupta, founder of crypto treasury management platform Coinshift points out that Aave, Maker and Compound alone have a combined TVL in the region of $26 billion and support multiple markets for lending and borrowing.

Assets exit AAVE 

Gupta made his comments at the start of June and the speed of the crypto lending platform collapse can be seen by the latest data from DEFI Llama, a website tracking the sector.

In the seven days up to 21 June, AAVE has seen a 12% drop in total assets and a staggering 47% fall over the previous 30 days. 

Despite this, others say that more obscure crypto lending platforms are worth a look. 

Celo is the most efficient blockchain for the general populace to leverage for crypto-based loans,” says David Casey, co-founder of credit platform ReSource. 

Learning the CELO

“This is because of the low gas fees (1/1000th of a penny) and the fact that the CELO blockchain is designed to run from a smartphone anywhere in the world.”

He doesn't consider what he calls ‘overcollateralized lending’ platforms such as Aave and Compound as sources of credit but rather as leverage or margin lending platforms for crypto traders. 

Instead Casey claims that the only other platforms offering true crypto credit are Goldfinch, Teller Finance, Union Finance, Centrifuge, and Masa.

Sadly the market disagrees and the CELO coin appears to have broken a string. According to data from CoinMarketCap, the digital token was trading at 93 US cents, down from $1.55 less than a month ago. 

CELO to USD 

George Harrap, co-founder of Solana portfolio dashboard Step Finance, unsurprisingly points towards the benefits of SOL backed crypto lending platform Solend.. 

The play on words in the firm’s title may be prescient given its current travails around a whale (a large crypto holder) holding enough assets in the system to see the ninth largest crypto by market capitalization fall to zero. 

Solend?

Assuming that does not happen Harrap says there are a number of reasons to consider SOL for crypto lending projects. 

“There are about half a dozen different loan platforms on Solana and it is probably the most efficient and cost effective platform to take loans out on any token,,” he says..

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Antoni Trenchev, co-founder and managing partner of Nexo - a regulated institution for digital assets - says every blockchain offers different transaction speeds, fees, privacy, and security.  

SOL to US dollar

Ethereum security “unparalleled”

“While Ethereum is the most widely-used blockchain, transaction gas fees can get steep at times,” he adds. “Polygon’s (MATIC)  network, on the other hand, is newer but more cost-efficient, and then there are chains like Avalanche (AVAX) that allow for great interoperability.”

According to Iron Bank external advisor ‘Lumberg’, layer 2 solutions such as Optimism and Arbitrum also show promise given that they inherit the security of Ethereum mainnet while offering faster transactions with lower fees.

Although the Polygon commit chain or high throughput chains such as Solana, Fantom (FTM) and AVAX are cheaper, Brian Pasfield, CTO at DeFi protocol Fringe Finance refers to the importance of security and suggests that in that regard, Ethereum is unparalleled. 

MATIC to US dollar

What are the risks of crypto lending?

Lending and borrowing through decentralized platforms require the user to lock tokens into a smart contract. Fringe Finance classifies the possible risks a user incurs under the following categories:

  • Liquidation loss - a user's loan goes under the collateralization line and they lose their collateral assets

  • Smart contract exploits – where a malicious user finds a way to hurt the platform by attacking its smart contracts, which can give them partial or total access to the tokens locked in the platform (examples of what can go wrong involve hackers changing proxy contracts or exploiting unsafe contracts)

  • Flash loan attacks - where a user takes advantage of a mistake in a platform's logic that allows them to quickly execute multiple loans, profiting from each subsequent one

Green flags for crypto lending platforms 

Before locking their coins into a network’s contract investors should look at the TVL of the various lending protocols as that is a good way of measuring their legitimacy, suggests Harrap. “The more money in the pools, the more people think the protocol is worthwhile,” he says.

Puff recommends users review the safety and security practices of the lending protocol that they use. Common security practices include software audits, bug bounty programs, insurance coverage, use of decentralized price oracles.

“The main risk surrounding borrowing from a crypto lender as opposed to using a DeFi protocol is the need for trust - namely, the lender running off with your collateral,” says Trenchev. 

“This is why users need to do their due diligence and ensure the platforms they engage with are audited, compliant, use third party custodians, and have insurance.”

Understanding the logic of crypto lending 

Faliushin advice taking time to understand the logic behind the process of crypto lending, avoiding taking a loan with the highest loan-to-value ratio and maintaining control of this ratio during the lending period.

“Potential borrowers need to know the terms and conditions of the loan and the service provider,” he says. 

“They also need to understand terms around lock-up periods when it comes to earning yield, which are different for every platform. 

From these terms you will be able to fully understand how the yield is being generated and how long are the lock-up periods to unlock the yield.”

To collateralize or not collateralize?

Other factors to consider include tokenomics (whether the economics behind the protocol are sound and whether the collateral is reliable and stable or highly volatile).

Casey observes that the risks of borrowing through crypto loan platforms differ depending on whether it is leverage/collateral-based lending or uncollateralized lending. 

“For the former there are all the normal risks of leverage, including massive liquidations such as what we have gone through over recent weeks,” he says. 

“For the latter the risks are more on the lender side, since recovery of funds is more difficult without collateral. KYC would need to be implemented for crypto credit to reach scale.” 

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