Protocol | Fintech

Crypto lending is taking off. Regulators may not be able to slow it down.

It's not clear what's worse for crypto investors and the companies catering to them: the present lack of guardrails or the impending arrival of stricter regulations.

Cyber piggy bank

DeFi lending is rewiring banking.

Illustration: D-Keine/Getty Images

Crypto lending has come under scrutiny from the Securities and Exchange Commission and state regulators. These products, which often tout high yields, are securities, the agencies have said.

The field is growing fast, despite increasing regulatory pressure. There are a host of ways crypto owners can get paid interest or its equivalent. Some are steeped in the decentralized finance (DeFi) world, while others have more connections with traditional finance. They vary in how they're set up and who operates them — details which may prove crucial both to investors seeking to navigate this world and regulators seeking to put guardrails in place.

Underlying crypto lending is crypto trading and speculation. There is strong demand to borrow crypto because hedge funds — and a range of investors — have found they can make money placing leveraged bets on tokens and crypto derivatives. Because these players can make considerable sums with their trading strategies, they can afford to pay middlemen high rates to borrow crypto. Those payments, minus a profitable cut, trickle down to ordinary crypto investors as yields that far exceed what they could get from bank deposits.

Of course, the products aren't FDIC-insured. And ultimately, the higher risk of the products explains why there are higher rewards. So far, there hasn't been a high-profile example of a crypto lending failure. But if there were a scenario where crypto tokens are loaned out and not returned, that could bring cascading failures throughout the crypto world and even the traditional finance system. That's why regulators are increasingly talking about the systemic financial risk crypto poses.

Coinbase canceled the launch of its Coinbase Lend program in September after the SEC said the offering was a security. And New York Attorney General Letitia James this month sent cease-and-desist orders to Celsius and Nexo on their interest-bearing products and requested information from three other companies.

Coinbase declined to comment for this story, but has laid out a proposal for a crypto policy framework that partially addresses its crypto lending product.

With interest rates still low, crypto developers have filled a void with DeFi. The premise of decentralized finance is cutting out middlemen such as banks and other financial institutions. Consumers and businesses are starting to use these products. There is more than $244 billion deposited on DeFi platforms.

DeFi and other forms of crypto-based lending might eventually threaten more traditional savings products, though conventional bank deposits have swelled to more than $17 trillion in the U.S. alone, a rise fueled by the pandemic. If anything, crypto lending has offered a welcome outlet for a tiny slice of that cash seeking yield.

Beyond satisfying the hunger for yield, crypto lending products are also a "fundamental building block of the industry," said Steven Goldfeder, co-founder of Offchain Labs. Most crypto projects need liquidity in their tokens in order to grow and scale operations, as well as to attract new developers to build applications or artists to create NFTs, he said. They also make it possible for users to invest or participate in new projects, he added.

But the financial aspects of DeFi products, even if they're built for other purposes, could get them regulated too — particularly if they provide tokens or incentives, SEC Chairman Gary Gensler has said. How exactly the SEC would regulate a decentralized system, which has no company owning it, is still not clear.

The interest in crypto

Several companies offer lending products that work much like Coinbase's proposed Lend would. They include BlockFi, Nexo and Celsius. Their products accept crypto and then pay earnings on them to customers. BlockFi offers about 8% interest back on bitcoin and other tokens, disclosing that it invests those holdings in equities and futures and loans them out in order to generate that yield. BlockFi has come under scrutiny from regulators in Alabama, New Jersey, Texas and Vermont for its Interest Account product.

Since these products aren't regulated, how exactly they earn yield for consumers — and how risky that is — is not always transparent. For example, BlockFi says: "BlockFi also engages in a number of other revenue-generating activities that support its balance sheet and its payment of crypto interest."

"We've been actively engaging with regulators to ensure they are well-versed on BlockFi's offerings," a BlockFi spokesperson said in a statement. "We believe that our products and services are lawful and appropriate for crypto market participants, and we remain steadfast in our commitment to protect consumers' rights to earn interest on their crypto assets."

The SEC has said these products are securities, based on the definition that an investment contract "exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others."

The SEC's stance flummoxed Coinbase CEO Brian Armstrong, who tweeted in September: "Seems strange — how can lending be a security?" His tweet drew ridicule, including an apparent subtweet from an SEC Twitter account that offered to explain bonds.

Based on a legal rule called the Howey Test that defines whether something is an investment contract and SEC v. Edwards, a 2004 Supreme Court case, it's "abundantly clear" that what Coinbase proposed was a security, said Dan Awrey, professor of law at Cornell University, who has written about regulation of banks and financial markets. "If you are investing money with someone with the expectation of receiving a profit, that investment is very likely a security," Awrey said.

There are also products that accept U.S. dollars from retail customers and convert the funds into cryptocurrencies on the back end. These customers only see fiat in their account. They're designed to make it easier for non-crypto experts to access the perceived financial upside of crypto.

One company, Outlet Finance, says it has historically gotten customers 6% to 9% yield. On the back end, Outlet converts the fiat into Terra UST and Celo CUSD stablecoins, said co-founder Patrick Manfra.

Outlet uses DeFi systems, such as Anchor, an automated lending protocol on the Terra network. When a user authorizes a payment to Outlet, Outlet's partner converts it to crypto, which goes directly to Terra or Celo, Manfra said.

"We stay out of the flow of funds, which are held by our custody providers," Manfra said. That's meant to avoid being categorized as a money transmitter, which could trigger state-level regulation.

Another company, Eco, converts customers' fiat to USDC and offers 2.5% to 5% yield. It uses a partner, Wyre, to lend out customers' USDC on the back end.

"Customers are increasingly tired of their money not working for them and are ready to take back control," said Eco CEO Andy Bromberg. "That often means searching for value that their bank isn't providing them anymore, and new fintech and crypto products can help provide that."

Crypto for business

There are products that have some regulation or are only for businesses, large institutions or accredited investors — which could limit their regulatory exposure. These include Circle's Circle Yield and Compound Labs' Treasury product. They're only open to accredited investors — and their backers have in some cases sought regulation as securities.

Compound Labs' Treasury product converts clients' dollars to USDC stablecoins, working with stablecoin provider Circle. Fireblocks provides the custody service. It then sends the token to the Compound protocol, a DeFi system that automatically lends it out to counterparties.

The Compound Treasury product provides a 4% return it says is "guaranteed." Compound's products are securities and are only offered to accredited investors or institutions, not retail investors, as Regulation D offerings under the SEC's Rule 506(c). In this sense, they're like investing in startups or a venture fund.

Circle, which is behind the USDC stablecoin, has its own regulated product, Circle Yield, which is only open to accredited investors. "Circle Yield is offered to U.S. investors as a security, and is exclusively offered to accredited investors as a private placement under an exemption to registration by Circle Bermuda. The activity is further overseen by the Bermuda Monetary Authority under our Digital Asset Business license," according to a Circle spokesperson.

BlockFi also has corporate treasury products, including BlockFi accounts for businesses, which are not specifically for accredited investors, and which are not registered securities. BlockFi also has crypto trust products for accredited investors.

The DeFi exception?

Finally, there are pure DeFi systems — some of which are used by crypto lenders to earn the money they then pay out to their customers. Compound and Anchor, for instance, enable people to put crypto assets on networks where they are automatically matched with borrowers.

Anchor, which launched in March, has about $5 billion in value locked on its system for lending. It was designed to offer higher earnings than traditional finance products in which interest rates were dropping close to zero, said Do Kwon, CEO of Terraform Labs, which built Terra and Anchor.

"There was ample opportunity for a capital-efficient lending protocol to swoop in, offer stable, attractive interest rates, and just capture a large part of the market, and that's exactly what we did," he said.

Whether and how DeFi products will be regulated is an open question. Anchor was launched by Terraform Labs, but now runs as an automated system operated by community members.

Kwon believes that regulatory approaches will depend on how genuinely decentralized systems turn out to be: "I think regulations are going to look at each of these protocols a little bit differently depending on the facts and circumstances and the degree of decentralization and the type of market they operate in." Kwon and his company recently sued the SEC over a subpoena he received from the agency.

Despite canceling its Lend program, Coinbase still pays holders of some tokens as much as 5% rates for staking tokens. Staking is a separate process where token holders deposit their tokens to support a protocol and help verify transactions. It's roughly analogous to mining in the bitcoin world, but it's seen as a more sophisticated and efficient way to support transactions on a blockchain.

Staked tokens aren't lent out in the same way — ownership stays with the original token holder, versus, say, BlockFi, which explicitly tells customers that a "digital asset is replaced with an obligation to return the same amount of that crypto."

Still, the fact that a lending system is decentralized or automated does not necessarily mean it's exempt from securities laws, says Cornell's Awrey.

The SEC is reportedly investigating Uniswap Labs, the company behind decentralized crypto exchange Uniswap, looking at how investors use Uniswap and how it is marketed.

The lack of clarity from U.S. regulators on crypto has left many entrepreneurs in the dark about what they can and can't do, said Bradley Tusk, co-founder at Tusk Venture Partners.

"This speaks to the underlying problem we have with crypto regulation," Tusk said. "Let's set some rules, whatever they are. Once they set some rules, everyone will complain. However, it gives them some rules to engage with."

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