The State Of Crypto Lending | Membrane Labs

This episode unravels the complex, interconnected world of crypto lending and borrowing, revealing how past failures have shaped the current landscape and what new risks and opportunities are emerging for investors.

The 2022 Crypto Lending Crisis: A Retrospective

• James, a veteran of the crypto lending space, recounts the "epic blowup" of 2022, triggered by the collapse of TerraLuna. The loss of confidence in TerraLuna's stablecoin system exposed a highly leveraged, poorly underwritten over-the-counter (OTC) lending market. Major players like Genesis, BlockFi, Celsius, and Voyager, fueled by retail deposits seeking yield, suffered massive losses.
• The interconnectedness of these platforms, coupled with a lack of due diligence and reliance on "promises and trust," created a domino effect.
• James emphasizes that the crisis stemmed from a "massive loss of confidence" that reverberated throughout the system.
• "You know, obviously there's a lot of Carnage and collateral damage that that impacts the system and then a massive loss of confidence over the next two years."

Exacerbating Factors: Venture-Backed Lending and Concentration Risk

• Venture-Backed Pressure: Many lenders were structured as venture-backed tech firms, incentivized to prioritize loan volume over risk management and underwriting standards.
• Concentration Risk: Three Arrows Capital was perceived as a "Goldman esque figure," attracting a disproportionate amount of capital and creating significant concentration risk.
• Operational Deficiencies: Many lenders relied on rudimentary tools like spreadsheets, failing to update loan-to-value (LTV) ratios in real-time or enforce margin calls effectively.
• "They were generally running everything in spreadsheets...they weren't updating their ltvs in real time."

The Flow of Funds: From Retail to Degenerate Gambling

• Retail investors deposited Bitcoin, Ether, and stablecoins into platforms like BlockFi, Celsius, and Gemini Earn, seeking yields of around 4-5%.
• These platforms then lent the funds to "the crypto street," including prime brokers and entities like Three Arrows Capital, often at higher interest rates (e.g., 7-8%).
• Three Arrows used the borrowed funds for various on-chain activities, including "degenerate gambling," assuming they could generate returns exceeding the borrowing costs.
• When Three Arrows' investments failed, the entire chain collapsed, ultimately impacting retail investors.

Systemic Interconnectedness and the Loss of Confidence

• Inter-lending: Lending platforms often lent to each other, creating a web of interconnectedness.
• Confidence Collapse: The failure of major players like TerraLuna and Three Arrows shattered confidence in the entire crypto lending ecosystem.
• Leverage Unwind: The lack of available leverage led to a sharp decline in asset prices, as many trading strategies relied on borrowed funds.
• "As soon as...all of the confidence is shaken to the core so everyone sort of retracts there's no leverage available in the system anymore."

Underwriting Failures and the Role of DeFi

• James emphasizes that the core issue was "a very weak level of underwriting standards."
• He contrasts the failures of centralized lenders with the resilience of DeFi protocols, which operated as designed due to their automated risk management mechanisms.
• Carson adds that DeFi saw continued activity even during the bear market, highlighting its functional superiority in risk management.
• The worst type of centralization was present, with players like FTX and 3 Arrows being put on a pedestal.

The Current State of Crypto Lending: Players and Dynamics

• Credit Crunch: Following the 2022 collapse, credit dried up significantly, with many players exiting the market.
• New Entrants: Over the past year, new lenders have emerged, filling the void left by the previous failures.
• Retail Aggregators: Platforms like Ledn are stepping in to serve the retail market, offering yield on crypto deposits.
• Borrower Categories: James identifies three main borrower groups:
  • Individuals seeking leverage or working capital.
  • Asset managers and institutions employing market-neutral strategies.
  • Miners, corporates, and wholesale lenders (e.g., FalconX, Hidden Road).
• Lender Categories:
  • Retail-focused platforms (e.g., Ledn).
  • Exchanges ramping up their lending services.
  • Custodians entering the lending space (e.g., BitGo).
  • Swiss banks and lenders operating in jurisdictions with clearer regulations.
• "We've had new entrance come in...more custodians getting into the lending game."

The Role of Foundations and Market Makers

• Foundations often lend their native tokens to market makers to ensure liquidity on both centralized and decentralized exchanges.
• These loans typically include embedded options, incentivizing market makers to support the token's price.
• The terms of these deals can vary depending on the project's clout, with established projects offering less favorable terms to market makers.
• Exchanges also demand substantial fees (cash or tokens) for listing, creating a challenging environment for new projects.
• "It's generally a loan with 0% interest so it's...strong-handed in favor of the market maker."

Institutional Lending: Challenges and Opportunities

• Regulatory Clarity: Harmonized global regulations are crucial for regulated institutions to engage with crypto lending on a larger scale.
• KYC/AML: Scalable solutions for Know Your Customer (KYC) and Anti-Money Laundering (AML) compliance are necessary for institutional participation in DeFi.
• Smart Contract Risk: The risk of smart contract hacks, such as the Lazarus Group exploits, deters institutions from deploying large sums into DeFi protocols.
• Custodial Solutions: Innovative models that combine on-chain assets with qualified custodians (similar to Copper ClearLoop) could mitigate some risks.
• Buy-Side vs. Sell-Side: Credit funds (buy-side) are showing more interest in crypto lending than banks (sell-side), which require definitive regulatory clarity.
• "The promise of upcoming regulations is not enough for a big bank to come into the space."

The Importance of Crypto Lending for Broader Adoption

• Personal Finance: Crypto assets are often treated as "zero" by traditional financial institutions, hindering access to mortgages and other financial products.
• Corporate Finance: Companies holding significant crypto reserves cannot leverage them effectively with traditional banks.
• Liquidity: The high liquidity of crypto assets makes them attractive collateral for lending, once regulatory hurdles are overcome.
• "Once we get these regulations I think you could see corporate financing mortgages all that kind it's a massive unlock that nobody's thinking about."

Membrane: Building a Platform for Institutional Lending

• Spreadsheet Solution: Membrane addresses the operational deficiencies of the past by providing a robust platform for managing loan books, derivatives, and trading.
• Custodian Agnostic: The platform integrates with various custodians and wallets, allowing users to manage their assets without funds flowing through Membrane.
• Real-Time Risk Management: Membrane enables real-time monitoring of collateralization levels and loan health.
• BitGo Partnership: BitGo's prime services are powered by Membrane's infrastructure.
• "Membrane is basically an Institutional platform...for Prime services."

Potential Risks and Future Outlook

• Improved Underwriting: Current lending practices are generally more collateralized and risk-averse than in 2022.
• Blurring of CeFi and DeFi: The increasing integration of centralized and decentralized finance creates new, potentially complex risks.
• Concentration Risk: While not as severe as with Three Arrows, concentration risk remains a concern, particularly around custodians and ETF providers.
• Centralized Exchange Hacks: The Bybit hack highlights the ongoing vulnerability of centralized exchanges, shaking confidence in the system.
• Undercollateralized Lending: The future of undercollateralized lending on-chain hinges on developing robust credit scoring mechanisms and secure asset custody solutions.
• Vaults: Vaults, like those offered by Morpho and Drift, are gaining popularity, offering composability and potentially attracting retail flows.
• Market Momentum: The growth of the lending market is highly dependent on overall market momentum and the absence of major negative events.
• "I think the...mixing of these things may lead to interesting...you're going to have this like that yeah."

The podcast underscores the transformative potential of crypto lending, while acknowledging the persistent risks and the need for continued evolution. Crypto AI investors and researchers should closely monitor the interplay between CeFi and DeFi, the emergence of new lending platforms, and the ongoing efforts to improve risk management and regulatory clarity, as these factors will significantly shape the future of the crypto lending landscape. The immediate takeaway is to prioritize platforms and strategies that demonstrate robust risk management and transparency, while recognizing the inherent volatility and interconnectedness of the crypto market.