Maximizing Returns and Avoiding Common Pitfalls in Crypto Lending

I'm speaking today with Anthony DeMartino. We'll discuss the challenges and changes in the crypto lending market post-Genesis, the significance of undercollateralized loans, and the evolving expectations of lenders and borrowers. 

Can you tell us about your background and how you got into crypto space? 

I’ve been in the financial industry for over twenty years, led trading businesses in major banks like HSBC, Barclays, and UBS. My roles have included managing top Agency and SSA business for both UBS and Barclays and spearheading Emerging Markets macro trading at Barclays.

In 2018, I transitioned to overseeing trading activities in key Latin American markets such as Brazil, Mexico, Argentina, and Chile. I got into crypto space in 2021 as CEO and founder of Coinbase Risk Strategies, focusing on DeFi and Derivatives trading.

And last year we launched Trident Digital Group to offer crypto-native solutions, particularly in lending, safe yield generation, and promoting stablecoin adoption in the digital asset landscape.

What are the major challenges currently facing the crypto lending market, especially in the wake of Genesis's and others' issues?

Away from the headlines about these institutions' spectacular failures, the events of 2022 have significantly changed the landscape, and the solutions that need to be provided in 2024 and beyond will look much different. Genesis was a very successful business; however, it failed in risk management. 

In the prior cycle, most of the lending came from retail and aggregators like Celsius and Blockfi. With those institutions gone, the market structure has shifted, with the old structure and aggregator model unlikely to be replicated. 

It was lucrative for centralized lenders like Genesis because the risk-adjusted terms were wildly in their favor, putting too much risk on retail. This time, with regulation becoming more expansive globally, it will be mainly institutions that lend, and the challenges will be having proper risk management, free of conflict of interest, and capital allocated at the right risk-adjusted terms. 

Can you provide a brief overview of the partnership between Trident Digital Group, Membrane Labs, and Electric Capital and the genesis of this groundbreaking AVAX token loan?

The partnership between Trident Digital and Membrane Labs involves Membrane providing loan booking and management services while Trident handles loan packaging, risk, and liquidity management. 

Trident's risk-reward dynamic attracted Electric Capital, an institution focused on risk management seeking additional yield. The approach blends traditional finance risk management with adjustments for the digital asset market's nuances.

Trident's "Lending Conduit" facilitates connections between institutional lenders and borrowers for risk-adjusted returns without commingling loans or cross-contagion risks to minimize counterparty risk. 

Emphasis is placed on optimizing security and transparency for lenders and providing capital efficiency for borrowers. The goal is to unlock dormant tokens on lenders' balance sheets, enabling lending on appropriate risk-adjusted terms.

How significant is the impact of overleveraging, lack of due diligence, and poor risk management in recent market turmoils?

The outcomes are apparent - we've already seen the impact of this lack of controls, and the appetite to repeat those same mistakes is quite limited regardless of how much the market rallies. 

Could you elaborate on investors' common pitfalls when participating in crypto lending?

It's the same pitfalls that traditional financial markets lenders get into - we've had these overleveraged, poorly risk-managed loans in the Savings & Loans Crisis, the GFC, and the Euro Crisis - they're all the same themes, replicated in different markets. 

If I had to classify into one issue, I would say it's the high optical yields and not understanding where they come from. People do due diligence when earning 5-6%, where they lack interest, but not when earning, say, 30%. It feels like the yields go up, and the rigor around risk management goes down - and that's not just crypto-specific.

Regarding overleveraging, what warning signs should investors be aware of to avoid potential losses?

I think it's two things: 1) who you lend to - meaning can they handle the leverage you're providing, from an institutional balance sheet perspective, and 2) the liquidity in the market - leverage should be a correlation to liquidity in the market. Whenever they are imbalanced, we see crises across many markets. 

Can you discuss the significance of the undercollateralized AVAX token loan executed by Trident Digital Group in partnership with Membrane Labs on behalf of Electric Capital?

This transaction proved our thesis on the new market structure. Our lending conduit introduces an "undercollateralized, over secured" solution, which solves the two current problems—it provides risk management, transparency, and security for the lender and material capital efficiency for the borrower. 

What are the primary obstacles in finding suitable replacements for Genesis in the current lending market?

Without the cheap, unsophisticated lending in the market, you get into this dynamic where the institution's appetite for unsecured loans is extremely limited because of the inability to do counterparty credit risk on most crypto companies, which are unregulated, unaudited, or, frankly, unprofessional. 

The other option before our solution was to lend overcollateralized - the problem with that, from the borrower's standpoint, is the capital inefficiency in this market. 

Cash and collateral are extremely expensive. There are fewer stablecoins in cash in the ecosystem as the markets rally, which puts a lot of pressure on borrowers to control their cost of capital. This is why we haven't seen significant lending over the last two years. 

How have lenders' and borrowers' expectations and requirements changed in the aftermath of Genesis and similar entities facing issues?

Given the extremely expensive cost of capital, borrowers' expectations revolve around increased capital efficiency. 

From the lenders' side (VCs, funds, exchanges, DAOs, and foundations), there is a higher sense of fiduciary responsibility to better manage the risk they're taking with their capital. This sets the bar much higher and much safer for the market.

What considerations are considered when structuring undercollateralized loans in the crypto space?

Our approach to risk management is twofold: pre-trade and post-trade. Pre-trade: We look at the historical sensitivity, liquidity, and volatility of the tokens we're looking to lend to determine the right collateralization ratios. 

The collateral is only as good as the ability to use it to get that out of the position. Post-trade: we run liquidity analysis continuously on our leveraged positions and monitor the ability to exit the positions, even the healthy ones. 

If we see a deterioration in the liquidity of the collateral, even if the loan is healthy, we force the borrowers to increase collateral or reduce the size of the loan to meet market liquidity. This has never really been done before.

How will the next generation of lending market participants differentiate themselves from those in the previous cycle regarding operations, risk management, and regulatory compliance?

I think the standard will have to be raised in all those areas, and there'll probably be a greater demand for risk and operational professionals to meet the increased scrutiny from the client base. 

Do I think we'll get to the perfect level in this cycle? I think that's ambitious. If markets get crazy enough, people will cut corners to get to market faster, and higher yields will attract clients again. 

Still, hopefully, the improvements made in this cycle will allow it to be sustainable, and defaults or losses will be much more manageable than catastrophic. 

Lending is not a risk-free endeavor, but the goal is to present lending opportunities with the proper risk and return profiles. 

What final advice would you give new and experienced investors looking to maximize returns and minimize risks in crypto lending?

They need to truly understand where the yields come from from the lending perspective because if they don't know where they come from, they are the yield. If they can't understand it, it's not worth doing.

It doesn't mean they have to know everything about every aspect of the market, but the bar should be: if you can't fully explain it to someone more senior than yourself, you shouldn't do it. Getting properly compensated for your capital based on your mandate for the risk you're taking should be important, so watch out for the risk-reward mismatch.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.