Authors: Emilios Avgouleas, Alexandros Seretakis Translation: Wang Han
The collapse of Genesis is the latest in a series of failures among cryptocurrency lenders. Last year, many major cryptocurrency lenders collapsed like dominoes. These failures exposed the vulnerability of the business model of cryptocurrency lenders, most notably the mismatch between liquidity and maturity in their loan portfolios, as well as their apparent weak corporate governance. This article explores the approach to regulating cryptocurrency lending within the EU financial services regulatory framework. It argues that cryptocurrency lenders should be considered as credit institutions under the definition of EU law and therefore should comply with the strict licensing and prudential requirements introduced by the Capital Requirements Directive and Regulation. The core part of the research was translated by the Institute of Financial Technology at Renmin University of China.
1. Introduction
One of the biggest challenges policymakers face in the cryptocurrency market is the handling of cryptocurrency lending. The President of the European Central Bank recently stated that the incidence of fraud, criminal transactions, and suspicious valuation practices in the area of cryptocurrency lending is increasing, posing serious risks to consumers, and cryptocurrency lending should be subject to regulation. One question that arises from her statement is: how should cryptocurrency lending be regulated?
- Coin Metrics What Changes Have Occurred in Ethereum’s One-Year Anniversary of the Merge
- Bitcoin Hard Fork History Both Split and Growth
- Token replacement, founder sued in court, how did former blockchain gaming king Gala Games fall from grace?
This article will explore the approach to regulating cryptocurrency lending within the EU financial services regulatory framework. It will argue that cryptocurrency lenders fall within the definition of credit institutions as provided by EU law. Therefore, they should comply with the strict licensing and prudential requirements set out in the Capital Requirements Directive and Regulation. It should be noted that cryptocurrency lenders primarily operate in the United States, and their operations in Europe are still limited. However, the significant growth of cryptocurrency lending in Europe may lead cryptocurrency lending companies to expand their operations in Europe, necessitating a regulatory response from European policymakers. A similar pattern can also be observed in the regulation of credit rating agencies. Although the three major credit rating agencies are based in the United States, their expansion in Europe and their role in exacerbating or triggering financial and sovereign debt crises have prompted European decision-makers to adopt a comprehensive regulatory framework.
In recent years, cryptocurrency lending has grown exponentially, and the failures of Celsium Network and Voyager have alerted policymakers to the importance of cryptocurrency lenders in the cryptocurrency market and the vulnerability of their business models. In addition, the shocking collapse of FTX has had a ripple effect throughout the industry and has had spillover effects on cryptocurrency lenders, with large companies such as Genesis and BlockFi suspending withdrawals of customer funds and applying for bankruptcy. As this article states, the activities of cryptocurrency lenders, including accepting deposits of cryptocurrency assets and granting cryptocurrency loans, are similar to banking activities. However, the lack of regulation has created a competitive advantage for cryptocurrency lenders compared to licensed banks. Unregulated cryptocurrency lenders are able to generate returns by taking on excessive risks.
In addition, as demonstrated by the recent crash of Celsius, the pro-cyclicality of cryptocurrency lending activities, the selling off of stocks held by investors in other asset classes, the high leverage employed, and the risk of depositor runs could lead to systemic risks. Prudent regulation will make cryptocurrency lending institutions safer and more stable. For example, prudent regulation can prevent cryptocurrency lenders from being exposed to a single asset class and can mitigate their vulnerability to liquidity risks (e.g., user runs). This will also limit the leverage capacity of cryptocurrency lenders. As a result, cryptocurrency lenders will become more stable and resilient, and a recent series of failures can also be avoided.
II. Decentralized Finance (DeFi) and Cryptocurrency Lending
2.1 Decentralized Finance/DeFi:
The combination of blockchain technology and smart contracts has given rise to a new form of financial ecosystem known as decentralized finance or DeFi. DeFi aims to replicate existing financial services without the involvement of central intermediaries. In the DeFi environment, users can maintain full control over their assets and interact with the ecosystem through peer-to-peer (P2P) and decentralized applications (dApps). DeFi applications do not require any intermediaries or arbitrators. Preset guidelines provide predictable dispute resolution mechanisms. Essentially, the code is the law among users, which is why it is referred to as “Lex Cryptographica” in the context of blockchain platforms. One of the purported advantages of DeFi is bypassing rent-seeking intermediaries in financial services and fostering a technologically innovative environment that offers consumers more choices in terms of payments and reducing transaction costs.
2.2 Nature of the DeFi Market:
The International Monetary Fund has stated that the significant growth and expansion of the cryptocurrency market pose risks to financial stability. The recent turbulence in the cryptocurrency market, including the DeFi market, has exposed structural vulnerabilities in the ecosystem. In particular, the chaos in the cryptocurrency market has exposed the volatility of cryptocurrency assets, with wild price fluctuations witnessed. Cryptocurrency assets exhibit greater extreme volatility compared to other financial assets. Furthermore, despite contrary claims, the correlation between changes in cryptocurrency asset prices and riskier assets such as stocks has been increasing in the past few years. Another major source of vulnerability is the ability of investors to build high leverage positions, exacerbating pro-cyclicality and volatility, and creating 25 invisible interconnected links, similar to other forms of shadow banking.
Most of today’s DeFi activities are outside the scope of regulation. Therefore, the European Commission recently proposed a Digital Finance Package aimed at promoting Europe’s competitiveness and innovation in the financial sector. The package includes legislative proposals for a digital finance strategy, retail payments strategy, crypto-assets, and digital operational resilience, as well as mapping the regulatory framework supporting market infrastructures based on distributed ledger technology. These are just the beginning, as EU financial services regulation will soon require comprehensive reforms to keep pace with the digital transformation of the EU’s internal and global financial value chains.
2.3 Special Cases of Crypto Lending:
The sudden collapse of Celsius and Voyager has drawn attention to the vulnerability of the business model of crypto lenders and their contribution to systemic risks. Crypto lenders such as Celsius and Voyager attempt to provide solutions to two different problems faced by cryptocurrency holders: lack of liquidity and lack of market purchasing power. Therefore, cryptocurrency holders who want to monetize their holdings can convert them into fiat currency. Additionally, it provides them with an opportunity to earn substantial returns from their cryptocurrency holdings through staking, which is only applicable to holders with large portfolios. Specific crypto lenders engage in collateralized loans, allowing holders to deposit their assets and borrow fiat currency or other digital assets against their cryptocurrency holdings as collateral.
Celsius offers a so-called “Earn” program that allows users to deposit digital assets into Celsius, and Celsius can use these assets to generate returns. Users receive asset rewards in the form of interest or Celsius tokens, with certain assets having an annual yield of up to 17%. The company generates revenue through various activities, including lending services, providing lending services to retail and institutional clients. Additionally, the company extends loans to clients with digital assets as collateral and allows them to re-collateralize. Furthermore, it engages in staking and deploys digital assets into automated market makers or lending protocols, charging fees. Losses suffered by certain illiquid investments and the collapse of the cryptocurrency market led to a large number of withdrawals by depositors, disrupting the stability of the company, which was forced to impose withdrawal restrictions to prevent depositors from leaving.
Voyager is a major crypto lender that applied for bankruptcy after the turmoil in the cryptocurrency market and a borrower default. Voyager operates a cryptocurrency platform that allows its users to trade and store cryptocurrencies. Customers can deposit their holdings of cryptocurrencies and earn interest. Voyager can pay deposit interest by lending the cryptocurrencies deposited on its platform to third parties at pre-negotiated rates. The general panic in the cryptocurrency market, the announcement by Celsius Network to suspend all account withdrawals and transfers, and the collapse of Three Arrows, a crypto fund that lent over $670 million, caused a run on Voyager by its customers. The company was forced to suspend withdrawals and trading activities on its platform and filed for bankruptcy.
Lastly, crypto lenders suffered a severe blow from the sudden collapse of the cryptocurrency exchange FTX. FTX used customer funds to provide funding for high-risk and illiquid bets by its affiliate trading firm, Alameda Research, but failed to meet the requirements. The resulting liquidity squeeze forced FTX to file for bankruptcy. The bankruptcy proceedings revealed aggressive speculative behavior, complete lack of corporate control and risk management, lack of transparency and reliable financial information, and self-trading.
III. Encrypted Lending: Risks and Regulatory Responses
The key financial stability threats of cryptocurrency lending arise from excessive volatility in the cryptocurrency market and the complexity and difficulty in valuing many crypto assets, such as non-fungible tokens (NFTs), and obtaining sufficient collateral to secure loans. As a result, leverage ratios within the system remain uncontrolled. This practice raises doubts and rumors about the financial health of cryptocurrency lenders, triggering market panics manifested as depositor runs. It exposes hidden liquidity imbalances within cryptocurrency lenders, leading to risks of liquidity shortage for both cryptocurrency lenders and cryptocurrency trading platforms. The activities of cryptocurrency lenders, including accepting cryptocurrency assets as deposits and granting cryptocurrency loans, are similar to those of credit institutions. According to the Capital Requirements Regulation (CRR), credit institutions are defined as “enterprises that receive deposits or other repayable funds from the public and grant credits for their own account.” Credit institutions are subject to strict licensing regimes, which are built on top of prudential rules introduced by the Capital Requirements Directive (CRD) and the Capital Requirements Regulation. These rules apply to banks and investment firms, including strict capital and liquidity requirements. Additionally, prudential supervision under the regulation extends to governance provisions aimed at ensuring independence and diversity of boards and strengthening risk management. System and control requirements will safeguard cryptocurrency lenders from risks of cyberattacks. Furthermore, the prudential rules establish remuneration limits to promote prudent risk-taking behavior and ensure that remuneration policies align with the long-term interests of the institution.
Cryptocurrency lenders that fall under the definition of credit institutions need to obtain a license in accordance with the Capital Requirements Directive and the standards set for assessing license applications. The European Central Bank has stated that when assessing license applications involving activities and services related to crypto assets, both the European Central Bank and national competent authorities must review how the proposed activities match the overall activities and risk profile of the institution, whether the policies and procedures of the institution are sufficient to identify and address the specific risks of crypto assets, and whether senior management and board members possess knowledge and experience in IT and the crypto market. The application of these licensing standards will ensure that only cryptocurrency lenders with sound business models, internal governance, and competent senior management will be able to obtain a credit institution license.
An additional benefit of the cryptocurrency lender licensing regime is that licensing authorities will also be subject to the MiFID II product governance regime. Therefore, they must disclose to users the historical volatility and default rates of their products, thereby minimizing any attempt to mislead investors regarding the true risks of the product and maximizing user/consumer protection. The product governance requirements introduced by MiFID II have proven to be one of the most important elements of the MiFID II investor protection framework, aiming to ensure that firms put customers’ best interests at the forefront throughout the life cycle of investment products and prevent improper sales practices. As part of the product governance requirements, the target market of each product must be identified and periodically reviewed, and a distribution strategy consistent with the identified target market must be developed. Additionally, assuming that cryptocurrency loans can be used for money laundering activities, the authorization will address this issue by default, as the authorized entities will be subject to “know your customer” (KYC) protection requirements for their customers.
IV. Conclusion
This article has studied the mechanism of a key part of the cryptocurrency market. It also suggests that cryptocurrency lenders should obtain licenses and regulations as credit institutions under EU law to enhance the stability of the cryptocurrency lending industry and create a fair competitive environment with mainstream lenders such as banks. A careful study of recent failures indicates that the industry is highly unstable, and the time for strict regulation has come to stabilize the industry, limit the contagion risk caused by a run on deposits, and prevent future bankruptcies.
It should be noted that Awrey and Macey also suggest a licensing regime for data aggregators in the context of open banking. However, the author’s suggestion is to control market power rather than promote financial stability as the current proposal does. A feasible alternative to licensing is systematically curbing consumer protection regulatory agencies’ promotion of cryptocurrency lending schemes. Nevertheless, regulating cryptocurrency lending schemes from a consumer protection perspective may not be sufficient to address the financial stability risks posed by their activities.
It can be said that the licensing regime for cryptocurrency lenders may herald the end of DeFi as an unregulated submarket. However, it should be noted that other parts of the cryptocurrency market, such as trading, will remain unaffected. Implementing prudent regulation for cryptocurrency lenders will certainly increase compliance burdens and costs, eroding the profitability of cryptocurrency lenders.
However, the recent collapse of FTX has shown that the business models and profits of many cryptocurrency companies are the result of regulatory arbitrage, weak corporate governance, excessive risk-taking, and outright fraud. In addition, the unregulated nature of cryptocurrency lending provides cryptocurrency lenders with an unfair advantage over regulated financial institutions such as banks, which are subject to strict prudential and business conduct rules. Although there is no evidence that cryptocurrency lending brings any specific benefits, the level and types of risks associated with this activity (market failures) fully demonstrate the justification for intrusive regulation, and prudent regulation is the most effective tool to control this activity.
Below are screenshots of parts of the article
Like what you're reading? Subscribe to our top stories.
We will continue to update Gambling Chain; if you have any questions or suggestions, please contact us!
