What are cryptocurrencies, and why were investors burned?

1. What is a crypto loan?

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

2. How big is cryptocurrency lending?

It is still small compared to traditional banking, but it has grown rapidly. Celsius said it had deposits of close to $ 11.8 billion on May 17, while BlockFi Inc. in mid-June declared deposits of more than $ 10 billion. Gemini Trust Co. began offering accounts in February 2021 and said in August last year that they had more than $ 3 billion in deposits.

3. How can they afford the big return?

The companies that offer the accounts say that they are able to lend customer deposits to other institutional investors at even higher prices. These institutions sometimes borrow crypto to carry out their own trades, for example to bet that the price of crypto will fall or to take advantage of price differences in other financial instruments. It is difficult to know what the crypto loan companies are invested in, as there are no uniform rules for them to reveal what deposits can and cannot be used for. The same applies to decentralized finance, or DeFi, instruments that also lure crypto investors with sky-high interest payments.

4. How do cryptocurrencies differ from DeFi?

Celsius, BlockFi and other crypto loan companies trade directly with their customers and pay them interest. With DeFi, it can only be a data code, instead of an intermediary, that manages borrowing and lending and interest payments. Lending crypto to earn interest via DeFi is sometimes called yield farming. This is again different from staking, where holders of a cryptocurrency allow their tokens to be used to help order transactions on the blockchain, or the digital ledger, used by that coin.

5. Why did some mortgage companies get into trouble?

Lending money to other people’s investments can be risky because if their efforts are poor and they can not pay you back, you are left with nothing. Celsius, Babel and Vauld all blamed the crypto market conditions for their liquidity problems. Celsius made a large investment in a token called stETH that allowed it to invest in the Ethereum blockchain and earn additional returns through DeFi. The sharp fall in the value of cryptocurrencies in May meant that stETH traded at a discount and the token became more illiquid. This made it more difficult for Celsius to collect money for redemptions when users wanted to withdraw their money. In June, withdrawals stopped in an apparent attempt to avert the digital equivalent of a bank run.

6. What have regulators done with cryptocurrencies?

Regulators and investors are concerned that consumers do not understand that they are taking much more risk than they would in a bank savings account. Because the crypto accounts are not FDIC insured, customers may lose their deposits if a company goes bankrupt, is hacked or otherwise loses customers’ funds. Few of the companies that offer the accounts first sought approval from US federal regulators, and this already led to a setback. In July 2021, securities regulators for Alabama, Texas, New Jersey, Kentucky and Vermont filed lawsuits against BlockFi alleging that the company offered unregistered securities. Several of the same states filed lawsuits against Celsius. Coinbase Global Inc. planned to offer similar accounts, but dropped the 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 payable to high-yield clients to lend their crypto as part of a record $ 100 million settlement with federal and state securities watchdogs.

7. What can change now?

The crises of Celsius and others may accelerate regulation. Financial watchdogs seem to see cryptocurrencies as some of the lowest hanging fruits in their attempts to bring law and order to the broader crypto industry. After all, with companies like Celsius and BlockFi, there is a clear entity to sue, which is not always the case in DeFi transactions.

8. What happens if cryptocurrencies are considered securities?

The term opens up a whole new regime with registrations and disclosure requirements to make products safer. This will probably mean higher costs for the crypto companies, and possibly the end of the huge return for investors.

More stories like this are available at bloomberg.com