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Crypto lending allows investors who hold cryptocurrency to lend their digital assets to different borrowers and to receive interest payments in exchange.Mark Blinch/Reuters

Over just the past two years, Ledn, a Toronto-based cryptocurrency lending company, has seen its digital assets under management grow from a couple of million dollars to almost $2-billion, fuelled by a surge in the number of users opening new accounts on its platform, according to Ledn co-founder Mauricio Di Bartolomeo.

Ledn offers various yield-generating crypto products, including bitcoin-backed loans and a bitcoin savings account. For simply parking your bitcoin with Ledn, you can earn up to 9.5-per-cent annual interest.

But despite already managing billions in digital assets, Ledn has not yet received full regulatory approval by the Ontario Securities Commission. Just six Canadian crypto platforms have so far been approved by regulators. All of them are crypto trading platforms, and are categorized as securities dealers. None are in the crypto lending business, like Ledn.

“We filed our registration and disclosed our business model to the OSC in March, but we are still waiting to complete the regulatory process,” Mr. Di Bartolomeo told The Globe and Mail. “We’re not sure yet how the OSC plans to designate us.”

Ledn’s registration status perhaps best illustrates a conundrum regulators face when it comes to the crypto industry. As soon as they decipher and deliver guidance on one kind of crypto business, various other new and often more complicated business models emerge, leaving authorities grappling with exactly how to regulate the new entities.

Crypto lending, to put it simply, allows investors who hold cryptocurrency to lend their digital assets to different borrowers and to receive interest payments in exchange. Borrowers are typically traders who use digital coins to trade various cryptocurrencies on crypto exchanges.

For years, traders have bought and sold cryptocurrencies, including bitcoin (BTC) and ether (ETH), on those platforms. Scores of crypto exchanges emerged, both domestically and abroad, and retail investor interest in the sector skyrocketed.

This past March, the Canadian Securities Administrators, the umbrella group of provincial and territorial securities commissions, issued guidelines on how to regulate crypto exchanges. The CSA determined these businesses are essentially securities dealers because they facilitate trades.

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Over the next eight months, Canadian crypto companies such as Coinberry, Bitbuy, Netcoins and Wealthsimple Crypto, all of which operate trading platforms, obtained “restricted dealer” status from regulators. That signalled to investors the platforms were safe to use.

In the meantime, however, crypto lending was gaining massive popularity, fuelling the growth of companies offering digital asset lending services that could allow Canadian investors to, in some cases, earn annual yields as high as 20 per cent by simply holding crypto.

Quebec’s giant pension plan, Caisse de dépôt et placement du Québec, even invested in a crypto lender, pouring hundreds of millions into U.K.-based Celsius Network, which operates a complex decentralized finance (or DeFi)-based lending platform.

But exactly how regulators intend to police crypto lenders is still unclear.

In a statement to The Globe, OSC spokesperson Crystal Jongeward said that based on the models of crypto lending companies the commission has seen, regulators “generally believe this type of activity falls within securities laws.” But the agency would not disclose how many Canadian crypto companies offer lending services and whether those companies have begun the process of obtaining regulatory approval.

“With the crypto exchanges, they effectively trade securities. So how they are regulated is pretty clear-cut,” said Jonathan Ip, a lawyer specializing in cryptocurrency at Toronto-based boutique firm Iterative Law. “But with companies that facilitate the lending of crypto, it is still not clear-cut, in that the regulators have not provided guidance saying that these products are definitely securities.”

Part of the issue for regulators is that crypto lending is highly complex and can take on various forms.

There is centralized crypto lending, such as the bitcoin savings account offered by Ledn, in which investors earn income, or yield, by just leaving crypto assets in an account. Like traditional financial institutions, the platforms offering these yields, which sometimes promote themselves as “savings wallets,” lend out crypto at higher rates than they offer to depositors, pocketing the difference.

Then there’s DeFi lending, which connects a user’s personal crypto wallet to a smart contract on the blockchain (think of it as connecting your money to an anonymous pool). The peer-to-peer arrangement of DeFi lending means that a user’s crypto is channelled into a liquidity pool that anyone can access.

If another user wants to borrow crypto from that pool, they have to provide collateral, in the form of crypto, into the pool. The borrowers are typically crypto traders who are similar to short-sellers of stock – they borrow crypto, sell it on exchanges and hope to earn a profit by buying coins later at a lower price to repay the loan.

But because everything is decentralized and run by software, there are no intermediaries, so you don’t know who is borrowing your crypto. The incentive for lenders, however, is to earn yield.

“If you have crypto in your wallet and you’re not planning to use it, why not lend it to somebody for a lucrative yield? That’s the thinking here,” Mr. Ip explained.

By many accounts, DeFi lending, in particular, is a booming industry.

DeFiPulse, a website that tracks crypto lending activity, estimates that over the past year, the total value of bitcoin and ether “locked” in lending protocols has risen from US$20-billion to more than US$105-billion. Aave, a Swiss company that is one of the biggest DeFi lending platforms, started the year with US$1.4-billion in crypto assets, and now holds US$14.8-billion, according to data from FRNT Financial Inc., a Toronto-based crypto derivatives trading platform.

According to Genesis, a New York-based crypto trader, lender and prime brokerage, crypto loan originations reached US$35.7-billion in the third quarter, up 586 per cent year over year.

In some ways, Mr. Di Bartolomeo of Ledn said, Canadian regulators are far ahead of U.S. authorities in terms of how they approach the crypto industry as a whole.

The debate in the U.S. still revolves around whether crypto assets are commodities or securities. Washington’s Securities and Exchange Commission has recommended that crypto trading platforms register with it, but has not mandated registration.

When it comes to crypto lenders, regulatory oversight has often been arbitrary. The San Francisco-based crypto giant Coinbase, for example, tried launching a crypto lending feature earlier this year. It received a warning letter from the SEC that did not explain why the lending platform was problematic, except to say that it would be considered a “security.”

At the same time, scores of American crypto lenders are operating and thriving, despite being unregulated. BlockFi, a New Jersey-based DeFi trading platform, was recently valued at US$3-billion after raising US$350-million in a funding round co-led by Bain Capital Ventures and the hedge fund Tiger Global.

“Canadian regulators took the co-ordinated approach to regulating crypto trading platforms as securities dealers. So now they can start going down their list, understanding different kinds of crypto businesses and determining how they can be regulated,” Mr. Di Bartolomeo said.

The concern for regulators with any crypto business always comes back to retail investors, and how to ensure assets do not get hacked. “I think regulators are still trying to get a sense of what protections are in place – who is on the other end of a crypto loan. But the whole point of DeFi is you don’t know who is borrowing your assets,” Mr. Ip said.

One of the biggest DeFi lending breaches in history occurred recently, when BadgerDAO, a lending protocol, was hacked, leading to the loss of US$120-million worth of bitcoin. Celsius Network, the company that the Caisse had invested in, was allegedly, according to various media reports, affected by the hack to the tune of US$54-million because it used Badger’s lending protocol as a way to expose its clients’ funds to a bigger lending pool.

But Celsius claims its users’ funds were not affected. “Our security team initiated a full scan of all Celsius DeFi wallets. We identified a compromised withdrawal and immediately shut down the attacker’s access to funds on the Badger platform,” the company tweeted in the aftermath of the hack.

Because Celsius is essentially unregulated (though its website states it is engaged in conversations about its business with various regulators around the world), it is complicated to figure out who exactly would be in charge of overseeing the firm, and responding to any kind of hack or company communication.

“This is exactly the danger. You’re relying on software. If these smart contracts are poorly written and vulnerable to hacks, you can lose your funds,” Mr. Ip said.

The Canadian company Bitbuy, which is now fully approved as a crypto trading platform by the OSC, attempted to tap into crypto lending back in 2019, by announcing a centralized lending platform alongside now-defunct Cred, a San Francisco-based crypto lender. (Cred, as it turns out, filed for bankruptcy late last year amid allegations of fraud and after falling victim to a hack of millions of dollars’ worth of bitcoin.)

Bitbuy’s chief executive officer Michael Arbus told The Globe the reason why the crypto lending product never commercially launched was because the company “did not have enough of a view on the regulatory posture of such a product.” He added that Bitbuy is only approved for spot trading, although it is possible that the company will explore crypto lending when regulators have clarified their position.

“I think they’ll get to regulating DeFi lending eventually,” Mr. Di Bartolomeo said. “It’s not an easy world to understand and it’s moving so quickly. Ultimately, it’s important that crypto businesses that operate in Canada, whether you’re a crypto lender or not, are very clear to the consumer as to what risks they are taking.”

Editor’s note: Attribution of a quote by Bitbuy’s chief executive officer Michael Arbus has been corrected in the online version of this story.

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