At first, very few people knew what to think or what to do with cryptocurrencies. What was it like money? What sustained the system? No one knew if it could be spent like real money or saved as a stock.
Today, a large percentage of people still cannot explain how cryptocurrency works. Although it has become more popular, it remains uncertain as an accepted form of money or financial security. A key aspect of this non-traditional currency includes its position on the decentralized ledger, also known as blockchain. Colbeck Capital Management recently discussed in their newsletter some of the challenges and rewards currently offered through blockchain loans.
What is the Blockchain loan?
There are a lot of concerns about crypto loans, and rightly so. With an anonymous currency, it can be tricky to get loans in the traditional sense. Cryptocurrencies are built on the understanding that intermediaries are not welcome.
With fewer middlemen involved in transferring or holding assets, there is hypothetically less opportunity for corrupt policies and slow systems to intervene. By removing system inefficiencies that hurt or exploit average consumers, you would have a smarter system, some say.
The cryptocurrency has sought to strike this balance. But without an intermediary, questions have arisen as to how currencies such as Bitcoin or Ethereum can be handled when it comes to lending. Can they be treated as assets when a consumer wants to hold them but needs the cash fast?
UCC, a standard developed long before the creation of cryptocurrency, defines them at best as general intangible assets. This is not ideal for loan situations as there is no way to establish a perfect lien in the event of default.
As a workaround, blockchain provides lenders with smart contracts that force lenders and borrowers to follow the same set of rules. If the borrower defaults on the loan, the smart contract will also act as a collector, immediately liquidating the crypto asset and sorting out the financial consequences of fees, debts, and remaining assets.
The growing world of DeFi
In this new world is DeFi, a marketplace of decentralized lending applications (Dapps) that work with an Ethereum-based smart contract system. Each Dapp defines its own contract protocol to establish a predictable environment.
Within these Dapps are pools of surplus funds which can be removed or added at any time. As the value of these loan pools changes, an algorithm adjusts the interest rate. Every 15 minutes, the price may change depending on supply and demand.
Some believe DeFi’s setup is way too close to traditional lending. They want cryptocurrency to be completely separate from traditional banking practices. But this separation can prevent widespread use of cryptocurrency, which has always been its intention.
One of the main differences is the agility of DeFi loans. Users can borrow or deposit into the pool at any time without penalty or taxable event. However, users should also be careful otherwise they will default on their loans if the values change too drastically.
Can You Default on a Blockchain Loan?
The flexible nature of blockchain loans means that you must have additional funds in your account at all times. You often lend at incredibly high rates of 150% to 200%, which are required for collateral.
This means that you need to have a much larger collateral than the amount you plan to take and use for your own purposes. If at any time you slip below this required amount, you are in default on the loan. This means that your assets held as collateral are immediately liquidated and that a penalty is added to the repayment of your loan.
Unfortunately, this has caught some traders off guard in the past. Colbeck noted that more than 775,000 traders had more than $ 8.5 billion worth of Ethereum and Bitcoin liquidated from their accounts when the price fluctuated beyond expectations. It is not something to be taken lightly.
Why promise a high guarantee?
When it comes to lenders, no one wants to support an anonymous account without a credit score or personal address. It is just too risky. The only way a lender will be tempted to take this risk is if the collateral is extremely high. This high-risk, high-yield lending approach has been in practice since the Black Death inspired new financial approaches in medieval Venice.
At such high rates, defaults are rare. But what makes a borrower take the high risk money for himself? In some cases, people find themselves in situations where they need a quick cash and can’t (or can’t) sell another asset. They’d rather put the asset on the block until they can reclaim that asset and move on, explained Jason Colodne, Managing Partner of Colbeck.
In other cases, the opposite can happen with people looking to take advantage of the bull-bear system by short selling the cryptocurrency. This includes taking out a loan when a currency market is low and then selling the currency when its price rises. There are costs associated with playing in the market.
For example, if the price of an ether (ETH) was $ 2,000 and you decided to sell it short, then you hope the price drops. Let’s say you borrow 5 ETH and exchange it for $ 10,000. When your prediction occurs and the price of ETH drops to $ 1,200, you buy back all 5 ETHs back to the lender, pocketing $ 4,000.
It also works in reverse. You can deposit a stablecoin (backed by an underlying asset, like the US dollar) to buy the cryptocurrency. When the price moves in the uptrend, you sell that cryptocurrency for more of the same stable coin, paying off your original debt with a little left over.
About Jason Colodne
As Managing Partner and co-founder of Colbeck Capital Management, Jason Colodne has spent the past two decades managing the investment and credit underwriting business. His role at Colbeck currently includes the Senior Trading Partner where he oversees the execution and management of the investment portfolio.
Prior to founding Colbeck, Colodne was Managing Director and Head of Strategic Finance at Morgan Stanley. Prior to working at Morgan Stanley, he was at Goldman Sachs where he headed Proprietary Distressed Investing and the Hybrid Lending Group in the Fixed Income Currencies and Commodities division.
About Colbeck Capital Management
Colbeck Capital Management is based on decades of combined financial expertise, offering non-traditional lending solutions for businesses facing periods of transition. Since Colbeck’s founding in 2009, Jason Beckman and Jason Colodne have overseen the firm as managing partners and expanded the business to include offices in New York and Los Angeles.
Interesting related article: “What are blocks?” “