Crypto craze sparks risky industry of loans backed by bitcoin

Marc van der Chijs, a venture capitalist and crypto entrepreneur, was considering loan options for the purchase of a new home this past spring – one of the options on the table was taking out a loan entirely secured by his bitcoin holdings.

The Vancouver-based co-founder of First Block Capital said he eventually backed away from the idea because of the high interest rate attached to crypto-backed loans, but he was motivated to explore it initially because of the “terrible, messy, process” involved with getting a traditional mortgage.

“A lot of my holdings are in cryptocurrency, and it took me almost two months to get a mortgage,” he told The Globe and Mail. Mr. Van Der Chijs said the crypto-loan platform Anchorage Financing, based in San Francisco, was willing to give him a loan worth hundreds of thousands of dollars within 24 hours.

Venture capital interest in the flourishing cryptocurrency market has spawned a cottage industry of crypto-lenders – companies that let clients borrow funds in cash against crypto assets the lender holds on the borrower’s behalf as collateral.

The interest rates on such loans tend to be high – sometimes as much as 20 per cent. But their appeal, say crypto enthusiasts, is that they allow investors who have large holdings of bitcoin and are unwilling to sell them to borrow against their digital assets.

“If you have a new asset class that’s worth over a trillion dollars, like cryptocurrency, it makes complete sense that people that own these assets want to use them in the same way as other traditional assets – stocks, bonds, property,” said Boris Wertz, an angel investor and the founder of Vancouver’s Version One Ventures.

In May, the Toronto-based bitcoin-lending platform Ledn raised $30-million in a Series A financing led by prominent VC backers who included Reddit co-founder Alexis Ohanian and the London-based hedge fund Kingsway Capital. Just two months earlier, BlockFi, a New Jersey-based crypto-lending platform widely considered a leader in the space, raised US$350-million, in a funding round that valued the company at US$3-billion.

Ledn co-founder Mauricio Di Bartolomeo said a significant number of users on his platform already own a substantial amount in bitcoin, but do not want to liquidate crypto holdings to purchase a large asset such as a house or a car. “The product was designed keeping in mind many cryptocurrency businesses and bitcoin-wealthy people that are poor in the eyes of the traditional banks, meaning that it’s hard for them to even get a line of credit,” Mr. Di Bartolomeo said.

The crypto-loan industry, however, has a long way to go before it becomes competitive with regular loans. Ledn charges users a 9.5 per cent interest rate for any bitcoin-backed loan, on top of a 2-per-cent user fee.

But because the price of bitcoin is so volatile, borrowers also have to double their collateral in order to take out a loan. For example, if you intend to borrow $1,000, your bitcoin deposits with Ledn must have a current value in excess of $2,000. Most crypto-lenders also have a specific method of calculating the loan-to-value ratio that takes into account crypto’s volatility.

Mr. Di Bartolomeo said Ledn’s system is designed such that if the price of bitcoin plunges to the point where the LTV ratio declines to 80 per cent, a client’s bitcoin is automatically sold to settle the outstanding loan. “Obviously we know that bitcoin is a volatile asset and therefore we have methods to protect against that volatility,” he said.

In Canada, crypto-lenders are only regulated by the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC) the country’s anti-money-laundering watchdog. Similar to banks, Ledn’s users, for example, will have to go through a standard know-your-client protocol set out by the regulator to ensure the platform is not being used for nefarious purposes.

But those rules do not protect users from losing their bitcoin collateral entirely, warns Henry Kim, co-director of the Blockchain Lab at York University’s Schulich School of Business. “Just to put it in perspective, if you want to consider using these products, one of the biggest risks is that the platform holding your assets could get hacked and your money could disappear. There’s simply no consumer protection against that,” he said.

There are, of course, ways to reduce that risk. Many large crypto-lenders, including California-based Silvergate Bank, use trusted custodians such as Fidelity Digital Assets. That essentially means Silvergate does not store a user’s digital assets itself, but outsources the service to Fidelity. Ledn uses BitGo, a cryptocurrency exchange owned by the asset management firm Galaxy Digital, as its custodian.

“It is generally sophisticated investors that are experimenting with products like this in the world of decentralized finance, so they know exactly what they are doing,” Mr. Kim said. “But it’s a sandbox. As long as crypto is stable and people see it as a buyable asset class, this all works well. If there’s an absolute collapse of crypto prices, then all hell breaks loose.”

Mr. Van Der Chijs, the crypto entrepreneur, says that while he is confident crypto-lending will become increasingly popular over time as cryptocurrency grows as an asset class, he often tells other crypto investors to borrow using just 10 per cent of their entire bitcoin holdings. “Don’t over-leverage yourself. That’s true for any asset class.”

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