What are crypto loans and how did BlockFi promise to change them?

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Savers frustrated with the paltry returns offered by banks in recent years seemed to have found a solution: so-called crypto loan accounts that pay interest rates of up to 18%. Millions amassed in these products offered by startups including Celsius Network, introducing a whole new cohort of investors to cryptocurrencies. Now it appears that some of those amazing returns may have been too good to be true. After amassing more than $20 billion in assets, including the life savings of many people, Celsius plunged into a solvency crisis that shook confidence in the largely unregulated world of crypto finance.

1. What are crypto loans?

At first glance, crypto loan accounts look a lot like the savings accounts offered by banks, but with crypto instead of traditional money. An investor opens an account, deposits cryptocurrencies and earns interest. Many deposits are in Bitcoin, while other investors use stablecoins, tokens whose price is often set at $1. Others use lesser-known and more volatile cryptocurrencies. Accounts typically pay interest in the same currencies that are deposited. Some have rates that change daily. Others offer a fixed rate and the money is locked for a fixed period.

2. How big is the cryptocurrency loan?

It’s still small compared to traditional banking, but it’s been growing fast. Celsius said it had about $11.8 billion in deposits on May 17, while BlockFi Inc. declared deposits of more than $10 billion. Gemini Trust Co. began offering accounts in February 2021 and said last August that it had more than $3 billion in deposits.

3. How can you afford the big returns?

The firms offering the accounts say they can lend client deposits to institutional investors at even higher rates. These institutions sometimes need to borrow cryptocurrencies to execute their own trades, such as betting that the price of cryptocurrencies will fall or to take advantage of price differences in other financial instruments. But regulators have said they believe some crypto lending firms are using the money for other business activities. Some may be investing client funds in riskier crypto projects, profiting from gambling and pocketing the difference. The bottom line is that there are no uniform rules for companies to disclose exactly what deposits can and cannot be used for. The same goes for decentralized financial instruments, or DeFi, which also attract crypto investors with sky-high interest payments.

4. How are crypto loans different from DeFi?

Celsius, BlockFi, and other crypto lending companies deal directly with their customers and pay them interest. With DeFi, it is just computer code, rather than an intermediary, that manages the interest payments. Lending cryptocurrencies to earn interest through DeFi is sometimes called yield farming. That, in turn, is different from staking, where holders of a cryptocurrency allow their tokens to be used to help order transactions on the blockchain, or digital ledger, that uses that currency.

5. What happened to Celsius?

The problem started after Celsius made a huge investment in a token called stETH. StETH allows people, and companies like Celsius, to stake on the Ethereum blockchain and earn additional returns through DeFi. A sharp drop in the value of crypto assets in May left stETH trading at a discount and the token becoming less liquid. That made it difficult for Celsius to collect money for redemptions when users wanted to withdraw their funds. On June 12, Celsius announced that it was suspending withdrawals due to “extreme market conditions,” an apparent effort to prevent the digital equivalent of a bank run.

6. What have regulators done about crypto lending?

Regulators and investor advocates worry that consumers don’t understand that they are taking on much more risk than they would in a bank savings account. Because crypto accounts are not FDIC insured, customers can lose their deposits if a company goes bankrupt, gets hacked, or loses their customer funds. Few of the companies offering the accounts first sought approval from US federal regulators, and that has already sparked a backlash. In July 2021, securities regulators in Alabama, Texas, New Jersey, Kentucky, and Vermont took action against BlockFi alleging that the company was offering unregistered securities. Several of the same states brought actions against Celsius. Coinbase Global Inc. planned to offer similar accounts but dropped that proposal after the Securities and Exchange Commission said it could sue the company. BlockFi announced in February that it would seek SEC approval for accounts that pay customers high returns for lending their crypto as part of a record $100 million settlement with federal and state securities regulators.

7. What might change as a result of Celsius’s problems?

The crisis in Celsius may accelerate the regulatory crackdown. Financial watchdogs seem to view crypto lenders as one of the lower fruits in their attempt to bring law and order to the crypto industry as a whole. After all, with companies like Celsius and BlockFi, there is a clear entity to sue, rather than just computer code like in some DeFi transactions. The SEC already more or less put an end to a boom in what was known as initial coin offerings, or ICOs, by entrepreneurs hoping to launch the next Bitcoin, when it ruled that most tokens counted as securities: stocks of ventures where investors pool funds and earn returns that depend on the actions of others.

8. What if crypto accounts are considered securities?

The designation opens companies to an entirely new regimen of registration and disclosure requirements to make products safer. That would likely mean higher costs for crypto companies and possibly an end to those gargantuan returns for investors.

More stories like this are available at bloomberg.com

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