Crypto lending has been gaining popularity in earning fixed-income earnings from cryptocurrencies. This type of loan is a perfect solution for retail investors looking to get returns on their crypto assets at attractive interest rates.
But crypto loans come with risks. Some of them are related to liquidity and market volatility.
1. Liquidity Issues
A liquidity crisis is a significant worry for crypto investors and platforms because lacking liquid assets can lead to mass withdrawals or bankruptcy. When centralized crypto exchanges and borrowing platforms have to use credit markets for short-term funding, they risk running out of cash or being unable to back their deposits.
Liquidity is buying and selling assets quickly with readily available and convertible funds. During a liquidity crisis, the price of an asset can rise or fall rapidly due to a lack of demand.
To prevent liquidity problems from escalating, many prominent centralized crypto exchanges and borrowing platforms have started to use fractional reserve lending models that trade with customer deposits to earn yields. However, if these platforms don’t have enough money to back their deposits or don’t have liquid assets, customers will lose confidence and rush to withdraw their funds.
This week, fear mounted on the crypto market that the liquidity troubles affecting cryptocurrency trading firm Alameda Research might spread to crypto lenders. On Tuesday, multiple institutional crypto capital firms maxed out their credit pools on Clearpool, an uncollateralized lending protocol. Amber Group, Auros, LedgerPrime, and Folkvang received a “warning” label on their respective Polygon Permissionless Pools on Clearpool because they reached 99% of the maximum amount of credit they could receive on the protocol.
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2. Regulatory Scrutiny
In the crypto lending market, fears are growing that regulators may take a hard line against lenders not compliant with traditional banking rules and regulations. This could have a chilling effect on the sector and potentially damage banks that rely on these companies to provide loans to their customers.
As the regulatory landscape in this space continues to evolve, we see several agencies taking different approaches to the issue. Some seek to regulate crypto-assets and fintech firms first, while others are more willing to work with industry players on settlements.
These contrasting views and the lack of clear guidance on regulating digital assets and their activities present a challenge for regulatory authorities. We need greater regulatory clarity and more cooperative action between governmental agencies.
This will require regulatory institutions to understand how rapidly-evolving technology interacts with traditional financial instruments. It also means that they must keep up with evolving risks and gaps in regulation. Ideally, this would allow them to make adjustments as needed in cases where they feel they have to do so.
3. Fraud
Crypto fraud is a common concern among users of the new Decentralized Finance (DeFi) market. Unlike traditional banking, there is no central entity to monitor DeFi platforms, and the absence of investor protection regulations can increase risks.
Fraudsters use a variety of methods to steal cryptocurrency. They can hack into accounts, steal personal information and transfer funds between exchanges.
Scammers also impersonate companies and tech support representatives. These phishing emails and text messages can lead users to divulge sensitive personal information or send money to fake accounts.
They can also manipulate users into downloading malware attachments to their devices, which can steal data from their computers. SIM-swap scams, which allow criminals to access a user’s phone and transfer cryptocurrency directly from there, are a growing problem.
These scams can occur on any platform, including email, social media, and SMS. The main aim is to gain control of essential user accounts by psychologically influencing them. Scammers can take as long as they need to get the victim to reveal keys or send money.
4. Market Volatility
A high degree of market volatility can indicate that a stock or asset may be ripe for a move. This can happen for various reasons, including rapid news cycles, speculators entering the market, and the rise of derivatives markets.
Financial indices like the S&P 500 and Euro Stoxx 50 can help investors measure the volatility of an asset in comparison to other assets or industries. In addition, risk benchmarks, such as CBOEs Volatility Index (VIX), can be used to gauge expected volatility in the broader market.
However, comparing volatility in the crypto lending market with other traditional asset classes is difficult. Because cryptocurrencies lack indices, no price or return indices track fluctuations across the market.
Creating a market-implied volatility index representing the full range of possible movements in crypto-asset prices is challenging. The only way to get a more representative measure of cryptocurrency volatility is to incorporate options trading into the indices. Currently, options liquidity is centered on Bitcoin, which limits the scope of this approach.
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