Overcoming Challenges of the Crypto Lending Market

In an executive order that surprised the crypto community, President Joe Biden called for the government to adopt a comprehensive approach to understanding and regulating cryptocurrencies and CBDCs. In essence, this order represented a nod of approval and did what Huobi Co-founder Du Jun echoed as injecting hope towards wider market adoption and institutional involvement through constructive regulation. This comes at a time when cryptocurrency trading and popularity is peaking, and issues with security risks are noticeably inhibiting the growth of the market.

Crypto credit lending has been one of the most profitable business models in the industry. The strong demand for crypto lending comes from investors and project developers alike – the former for leveraged bets on tokens and crypto derivatives, and the latter for much needed liquidity to support growth and development, be it an exchange, DAO or market-making app.

Huobi Research published a report titled “Finding the Next Growth Engine for Crypto Lending Markets”, identifying three key issues that are restraining the growth of crypto lending: Know Your Customer (KYC), risk management and risk pricing. In order to unlock its growth potential, the on-chain crypto credit market needs to step up risk management, develop interest rate pricing linked to a market-based mechanism, and support lending to on-chain legal entities.

Key factors stagnating the growth of crypto lending

The use of a crypto asset as collateral runs some obvious risks, in addition to asset volatility in the decentralized market. Below are the three key issues identified by Huobi Research Institute as preventing crypto lending from taking off:   

KYC: The anonymity of the blockchain network and the lack of identity and background authentication of the borrower contributes to a high risk of default.

Risk management: Compared with traditional finance, the crypto lending market lacks a track record and data, and the execution of risk management models, which are common for its off-chain counterparts, is no small challenge.

Risk pricing: Due to the homogeneity of collateral, excess mortgages can complete interest rate pricing in accordance with market mechanisms. However, due to the differences in entities, the risk premium for crypto lending will be different, and pricing will be more difficult.

Recommendations to strengthen the crypto lending market:

Lending to on-chain legal persons: On-chain credit loans should be granted to only two types of borrowers – a natural person or legal person who has done KYC off-chain, and accountable corporates with substantial financial interests on-chain such as DeFi head protocols and Decentralized Autonomous Organizations (DAO).

Stepped-up risk management: Similar to traditional financial markets, future crypto lending markets can take guidance from the risk management framework of the Basel Accords. Credit risk management, credit default probability, default loss ratio and other indicators could be calculated through internal rating and credit risk measurement models.

Market-based mechanism for risk pricing: With detailed rating and credit risk metrics, the market can be given a pricing reference, and market pricing could be achieved through a Dutch auction.

As recognition and resources surrounding these challenges increase and governments act on mitigating risks within crypto markets through regulation, we can hope for improved growth and credibility in the crypto lending market.

To read the full report, click here.

This is the first piece of several under the “Discovering the Unicorns of the Future” series of research reports, which will track key industry trends and provide insights on the industry outlook.