Letter #37: The True Cost Of Crypto-Collateralized Loans
Can You Really Get a Loan With 0% Interest?
The world we live in today is highly financialized. Banks and fintechs permeate almost every aspect of our lives, from the payment services we use to buy our groceries to the loans we take out for our business, homes, cars, and more. Our reliance on financial services and the companies that offer them has become so complete that even industries that typically don’t deal in finance, like social media, are beginning to incorporate financial offerings into their products. Do you remember Facebook’s bid in mid-2019 to issue its own stablecoin to its nearly three billion users? If it were to succeed at a future point, Facebook would easily become the largest financial services company in the world overnight.
The majority of banks, investment firms, and insurance companies that we build our financial relationships with have had decades, if not longer, to perfect their craft. It’s rather surprising then that they’re all so bad at it. Users and account holders are charged exorbitantly high fees and receive extremely low returns for their money. Let’s not forget as well that banks and hedge funds, among others, contributed to leading the world into one of the worst recessions in history over a decade ago. While these companies surely shoulder the bulk of the blame for their poor performance, it’s not all their fault. After all, most of their customer-facing products and services are over-regulated to the point of stifling innovation and they run on top of legacy systems, like the Automated Clearing House Network, that are decades old.
Out of the ashes of the aforementioned Great Recession arose a brand new financial system. Bitcoin, blockchain, and cryptocurrency provide a better way for individuals and companies to protect their earnings and conduct their financial business. As a result, an entirely new group of companies, products, and services are being built. There is no doubt that they won’t all make the cut. Most new companies fail within their first several years and that will certainly be the case with crypto companies and protocols. However, those who come out on top will have the opportunity to completely revolutionize the way humanity interacts with its money and the services built with it.
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Crypto Banks: One Foot in Both Worlds
While the world is trying to work out the kinks with DeFi and other parts of the new financial order, there are a growing number of companies who are happy to straddle the line between the old and new. The most prominent of these companies are known as crypto banks, and that couldn’t be a more appropriate name for them considering their service offerings are largely identical to those of traditional banks. The obvious difference of course is that they cater more to crypto users than to fiat users.
Regardless of the similarities, crypto banking is becoming big business and the companies operating within the space are experiencing a massive amount of growth:
In the grand scheme of things, this shouldn’t come as a surprise to us. Cryptocurrency and blockchain currently operate in a regulatory gray area, meaning that accessibility to the crypto banks’ services is often much greater for the average user than to those of traditional financial companies. Additionally, crypto banks are incurring massive amounts of acquisition and retention costs for their customers, as evidenced by the fact that most of them continued to pay 5-10% interest on deposits even during the recent bearish downturn in the cryptocurrency market.
Crypto-Collateralized Loans vs. Traditional Loans
While interest-bearing deposit accounts are the primary service offered by most crypto banks, the companies do spend a significant amount of effort trying to differentiate themselves from their traditional counterparts in another category: loan servicing. To illustrate this difference, let’s take a brief look at what the loan process looks like in the United States:
A borrower approaches a bank or other financial institution, likely one with which the borrower has already established a relationship, to open a credit card or take out a loan for a large purchase. The borrower comes prepared with a large amount of personal information such as their social security number, birth date, personal identification card, recent pay stubs….the list goes on. The financial institution performs a credit check and background check on the borrower to determine their ability to repay and their trustworthiness to receive the financial service. If the borrower passes those checks, they finally sign a mountain of paperwork and agree to pay an often massive interest rate, commensurate with the type of loan or financial service for which they have applied. If the whole process seems burdensome and overdone, you’re not wrong. What matters when taking a loan out with a traditional financial institution is trust and your trustworthiness is represented by a credit score and by the exorbitant amount of personal information you are required to provide.
The process of taking out a loan from a crypto bank is very different because, like with blockchain, the whole process relies very little on trust. A borrower’s ability to repay is determined by nothing more than their ability to post a sufficient amount of collateral to back the requested loan. In fact, within certain DeFi protocols, borrowers are not even required to provide any personal identifying information before taking out a loan.
Collateralized loans should not be wholly unfamiliar to us. After all, mortgages are collateralized by the houses purchased and car loans are collateralized by the cars. A loan with a company or protocol sitting on top of a blockchain requires a digital form of collateral though, and that is where cryptocurrency as collateral enters the picture. In order to take out the loan, borrowers are typically required to deposit their cryptocurrency assets into a crypto bank’s wallets or into a lending protocol’s loan pools.
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Loans Collateralized With Crypto Are Not All They Appear To Be
Crypto-collateralized loans are advertised as an improvement over traditional loans, and in some regards they are. However, there are less visible costs to taking out a crypto-collateralized loan that are almost never advertised. One of the biggest is that assets used as collateral do not earn interest. Since the loans are almost always required to be over-collateralized (referred to as “Loan to Value” or “LTV” in crypto parlance), lost interest can add up significantly over the loan’s lifetime. Let’s take a look at a pair of examples:
The lowest loan interest rate offered by BlockFi is advertised as 4.5%. While some borrowers will likely be subject to higher rates, we’ll use 4.5% for simplicity’s sake. As seen in the image above, this loan by BlockFi requires a Loan to Value of 50%, meaning that the borrower has to deposit collateral worth twice as much as the value of the loan. So a $10,000 loan will require $20,000 worth of Bitcoin backing it. Since BlockFi offers a 4% interest rate on Bitcoin deposits, let’s do a quick back of the envelope calculation to calculate the true annual cost of this hypothetical loan:
Base Interest Paid: 4.5% x $10,000 = $450
Interest Lost on Collateral: 4% x $20,000 = $800
Total Loan Cost: $1,250 or 12.5%
The lowest loan interest rate offered by Abra is advertised as 0%, which surely appeals to a lot of potential borrowers. Again, Abra offers other rates with different LTVs, but we’ll use 0% to keep it simple. This offering from Abra comes with a Loan to Value requirement of 10%, meaning that the borrower has to deposit collateral worth TEN TIMES the value of their loan. The same $10,000 loan we looked at before would require $100,000 worth of Bitcoin backing it. Since Abra offers a 3.15% interest rate on Bitcoin deposits, let’s do another back of the envelope calculation for this loan’s real annual cost:
Base Interest Paid: 0% x $10,000 = $0
Interest Lost on Collateral: 3.15% x $100,000 = $3,150
Total Loan Cost: $3,150 or 31.5%
The above examples don’t account for all costs associated with taking out a crypto loan, such as origination fees or lost collateral if the crypto bank gets hacked or goes under. They also don't account for the fluctuating value of cryptocurrency and associated interest earned. However, even without the whole picture, the true cost of crypto-collateralized loans is much greater than what crypto banks would like us to believe.
While crypto-collateralized loans can be useful in certain situations, like when a user can’t get a loan through the legacy financial system, they come with significant costs and risks, many of which are unknown to the average user. Anyone interested in potentially taking out a loan from their crypto bank should certainly weigh both the positives and negatives before moving forward. Not doing so could end up costing you a lot more than you ever realized.
Crypto Roundup 🤠
Crypto Accessibility: Citibank, one of the largest banks in the U.S., is making tentative plans to open up Bitcoin futures trading for a subset of its wealthiest clients. Read more
Institutional Investment: The Grayscale Bitcoin Trust (GBTC), a proxy investment tool for Bitcoin, concluded its final share unlocking for 2021, ending associated bearish FUD for the year. Read more
Crypto Bets: Venture Capitalist Bill Gurley indicated that he has taken a personal position in Ethereum after being “swayed by the arguments of the [crypto’s] crowd.” Read more
Into the Twitterverse 🐥
Government excess is staggering. Every dollar, rupee, euro, or other fiat printed out of thin air devalues the fiat in your wallet and bank account:
Imagine not having the freedom to spend and invest your money how you want:
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This is not financial advice. This newsletter and related content are for informational purposes only. Cryptocurrencies, stocks, and similar assets can be risky. Always do your own research before making any sort of investment.