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This article was originally published in Global Risk Regulator, 6 July 2022, and can be found here.

Celsius blow-up highlights areas for improving crypto lending platforms

Manoj Mistry, Managing Director, IBOS Association

The volatile performance of crypto currencies has made significant headlines over the past year. No wonder. Bitcoin, easily the best-known crypto, has fallen by 70% in value since reaching its peak last November. Simultaneously, the aggregate value of the entire crypto market has fallen from just over $3trn to less than $950bn today. If 2021 can be readily characterised as a strong bull market for crypto assets, then 2022 has seen the reverse: a sustained bear market in which crypto values have consistently fallen by significant margins across the board.

This asset squeeze, commonly labelled by global media as the crypto winter, has created significant problems for both investors and platforms alike. The Celsius Network has emerged as the most prominent victim to date. On 12 June, the crypto lending platform announced that it had suddenly blocked all withdrawals, swaps and transfers by its 1.7 m clients, citing “extreme market conditions” as the reason. Despite these restrictions, Celsius has continued to receive some new client deposits.

In total, Celsius had in excess of $8bn lent out to these clients and $11.8bn in assets under management at the time of its announcement. Since then, Celsius clients have been unable to withdraw or transfer bitcoin and other cryptocurrencies on its network. According to the Wall Street Journal, Celsius has recently hired restructuring consultants from Alvarez & Marsal to assist with a potential bankruptcy filing.

Going down the Chapter 11 route would allow Celsius to restructure its debt and obligations under supervision from the court while it continues to operate. That prospect inevitably focuses attention on a much wider group of crypto lending platforms that have become an important engine in powering the growth of cutting-edge industry projects.

Although there is no immediate prospect of market contagion, it nevertheless serves to undermine the embryonic crypto sector. This matters because lending platforms are essential to the development of the crypto market as it evolves and matures.

Whatever happens to Celsius in the coming weeks and months, crypto lending platforms are essential for the long-term future of the digital asset market. In essence, the core business model of these lenders is remarkably similar to that of a traditional consumer bank: the platform takes deposits from customers and then lends that money out, mainly to institutional borrowers.

Consumers have been enticed to these platforms by the attractive interest rates on offer. Typically, these are much higher than those offered by conventional banks and traditional investment vehicles – often in the 7 to 15 per cent range. It is therefore no surprise that such high yields have led to many millions of investors being drawn into the crypto market.

Some of the deposit money received by crypto platforms goes into financing new developments in the crypto industry, such as decentralised finance (DeFi) projects that aim to replicate the existing financial system, but without centralised authority. DeFi allows individuals to operate without approval from a third party as lending products secure outstanding loans through over-collateralization. Thanks to the use of smart contracts, maintenance margins and interest rates are programmed directly into a borrowing agreement. Should an account balance fall below a collateral ratio specified in the smart contract, liquidations happen automatically.

Another factor highlighted by the Celsius problems and the broader decline in crypto asset values is the absence of specific crypto regulation, and where it does exist, a lack of consistent application.

A lack of continuity certainly exists between the various US regulators, for example. Currently there are diverse legal approaches at a state level, while progress is being made, albeit slowly, in developing federal crypto legislation. The Financial Crimes Enforcement Network (FinCEN) does not regard cryptos as legal tender, but does consider crypto exchanges to be money transmitters, predicated on the basis that crypto tokens are “other value that substitutes for currency.” Meanwhile, the Internal Revenue Service (IRS) defines crypto as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value”. That sounds like a definition of money.

US crypto exchanges fall under the scope of the Bank Secrecy Act (BSA). In practice, they have to register with FinCEN, implement an AML/CFT programme, keep appropriate records, and submit relevant information to the authorities. Meanwhile, the US Securities and Exchange Commission (SEC) considers cryptocurrencies to be securities, and therefore applies securities laws to digital wallets and exchanges, whereas the Commodities Futures Trading Commission (CFTC) describes Bitcoin as a commodity and allows cryptocurrency derivatives to trade publicly.

Although the lack of crypto-specific regulation and ultimately continuity between different jurisdictions continues to exercise the minds of central bankers and policy makers worldwide, it seems likely that a swathe of regulations will be delivered in the next few years – at least on both sides of the Atlantic. In the interim, other factors such as hacking, fraud and design faults continue to pose risks for investors. Notwithstanding these teething problems as regulators, lawyers and cyber security experts get to grips with the assorted challenges, lending platforms will remain integral to developing the crypto and DeFi markets of the future.