This is a two-part series which outlines the problems that exist amongst crypto-backed lending solutions today. The first post in our series focuses on the issues surrounding centralized lending solutions such as SALT Lending, NEXO, and BlockFi. You can read Part 2 about decentralized lending solutions here.

In September of last year, for the first time in my life, I was late paying rent and nearly evicted. Why? Because cryptocurrency-backed loans give me grief. Allow me to explain…

Crypto-backed loans — A brief primer

Deposit your bitcoin, ether, or some other crypto-asset as collateral, and get cash or stablecoin back as a loan. Keep HODLing. No selling. No capital gains tax. Sounds simple enough, right?

Beginning with the launch of SALT Lending in late-2017, this simple idea has managed to spawn a whole new industry of centralized lending platforms with players like Nexo, BlockFi, and the afore-mentioned SALT competing with one another by providing lower rates, having faster approval processes, and allowing more favorable collateralization ratios. These platforms required users to deposit their crypto-collateral with some trusted custodian for the duration of the loan.

And then came the dApp developers, who created decentralized lending solutions like ETHLend and MakerDAO that allowed you to do essentially the same thing, but worked exclusively through Ethereum smart contracts. This means that the collateral was held in the smart contracts themselves, rather than some centralized custodian.

So back in September, when the due date for rent came rolling around, I thought: “I need fiat. I want to hold on to my bitcoin and not pay capital gains tax. Doesn’t a crypto-backed loan sound like the perfect solution?” Well, the problem is, while the idea of a crypto-backed loan certainly fit what I needed, the implementations out there at the time did not.

A visual comparison of some existing crypto-lending solutions in the market today — both centralized and decentralized. The horizontal axis represents the degree of centralization. The vertical axis represents the extent to which assets on multiple blockchains can be used as collateral or borrowed on the platform/protocol.

Centralized lending solutions — A step backwards?

From the day Satoshi released the Bitcoin whitepaper to the masses, cryptocurrencies and blockchain have been predicated on the concept of architectural decentralization. By validating every transaction on a distributed group of miners that exist on the Bitcoin network, Bitcoin mining effectively decentralizes the transaction clearing and currency-issuance functions that are performed by a central bank.

Risk of funds stolen

Despite this, centralized exchanges rule the ecosystem. As most are aware, centralized exchanges intermediate as middle-men to allow trading on the platform, maintaining total control of private keys that unlock the funds of every user and hence facilitating every transaction on the platform. Despite the resilience demonstrated by Bitcoin, Ethereum and other cryptocurrencies against malicious actors and government intervention, the centralized exchanges on which they trade can shut down or disappear at any time, representing single points of failure against these threats. From Mt. Gox in 2011 to Coincheck in 2018, centralized exchanges have proven time and time again that they suffer from a systemic vulnerability to being hacked. In fact, 2018 saw a 13-fold increase in funds stolen from cryptocurrency exchanges compared to the previous year. On average, that’s $2.7 million in crypto-assets that are stolen every day. Meanwhile, the centralized nature of exchanges like Upbit and most recently, BitMEX, has made them susceptible to government intervention and regulatory uncertainty.

In the lending space, concerning parallels have emerged. Like centralized exchanges, their cousins in lending were first to market and dominate much of the market volume. Centralized lending platforms also require users to delegate trust to the platform or a custodian partner for control over their funds, just like their centralized exchange counterparts. For instance, to borrow on Nexo, one must first deposit crypto-assets on the Nexo platform as collateral. Across centralized lending platforms, with the process of requiring borrowers to forfeit complete control of their assets and store collateral with a single party, borrowers run the risk of having their collateral funds seized or inaccessible through hacks and downtime. This greatly accentuates the increased counterparty risk that borrowers experience. My skepticism surrounding collateral safety and the risk of a breach on centralized lending platforms was what ultimately became the most important factor in my decision to avoid such platforms.

Do you agree with these issues? Are there other problems you see with centralized loan platforms? Comment below, add your email here, or email us your thoughts at tony@atomicloans.io.

KYC/AML and other barriers of entry

Being located in a country outside the US, I understand that our country is usually not the first when it comes to the list of jurisdictions on the release roadmap. But when the core premise of a business is providing loans backed by an “open and borderless” cryptocurrency and yet said business is available to consumers only in select states in the US plus 8 other countries and territories (a combined population that makes up just 7.64% of Earth’s population), we might have a problem. But such is the case with SALT Lending, the platform that was the pioneer of centralized crypto-lending and still is one of the most prominent centralized lending solutions on the market today. While platforms like Nexo claim to be globally accessible in an astounding 200+ jurisdictions, so long as Nexo continues to function as centralized custodians of customer funds, it remains highly vulnerable to government intervention in the event authorities change their minds.

A map of the jurisdictions SALT Lending is currently available in. Green represents regions in which SALT provides both business and personal loans. Blue represents regions in which SALT provides business loans only. The green regions represent just 7.64% of Earth’s population, meaning only 7.64% of individuals have access to consumer loans through SALT.

Additionally, jurisdictions aside, if I ever wanted to lend some of my assets down the road to make some passive income, I might find myself having a bit of a rough go. Most often, centralized lending platforms either act as the sole lender themselves and pursue lending capital by fundraising from VC’s and institutions, as is the case with BlockFi, or in the case of platforms like SALT, individuals must possess a minimum net worth to be permitted as a lender on the platform.

And then, there’s the infamous KYC/AML process (know-your-customer / anti-money laundering) one must go through while using such centralized services. While these processes have come a long way since the early days of crypto in terms of speed and ease of use, the fact that it opens up a brand new vulnerability of identity theft is enough to annoy any privacy-conscious individual. More importantly, KYC/AML serves to exclude the 1.7 billion unbanked individuals who lack the proper documentation to prove their identity. Doesn’t this seem like a particularly difficult pill to swallow when combined with one of blockchain’s more popular mantras, “banking the unbanked”?

Lack of loan term flexibility

Say what you will about the problems surrounding the traditional debt market, but a large reason why the global debt market has evolved to be the $213 trillion behemoth that it is today is due in large part to the flexibility and choice that exists in debt. Both borrowers and lenders (bond issuers and investors) have a multitude of choices when it comes to the structure, length, and risk profile of the loans they want to partake in, and more often than not, they’ll find something in the market with terms that work for them.

This is simply not true on centralized crypto-lending platforms in the market today. Whether it’s the size of the loan, the length, the collateralization ratio, or the interest rate, it is the platforms that dictate the terms in almost every instance, no questions asked. While I understand that these platforms likely arrived at these specific terms following rigorous credit risk and market assessment, my point remains that people should have the choice and the flexibility to borrow and lend in a manner that fits their unique needs, rather than having to conform to the rules and fees that someone else came up with. So if I was behind on my credit card payments and wanted a quick week-long 1:1 bitcoin-backed loan for $2500 at 25% APR (~0.5% interest for the week), I shall get one, so long as there exists a lender who is willing and able fulfill the loan.

Advertised loan terms on BlockFi. When asked to clarify the use of “Up to” and “Starting at”, a BlockFi representative stated that the terms of each loan are negotiated on a case-by-case basis.

On a similar note, centralized lending platforms are notoriously slow in adding support for new assets for collateral and stablecoins that can be borrowed. If crypto-backed loans are to truly appeal to the masses, such bottlenecks should not exist. Traditional lending markets aren’t just restricted to USD, EUR, or GBP, so why should I be limited to only using BTC, ETH, or LTC as collateral in a crypto-backed loan?

The initial page of the loan application process on BlockFi. Notice the minimum and maximum loan amounts, the default 35% LTV ratio, and the limitation to only being able to choose between BTC, ETH, and LTC as collateral.

Token friction

As the ICO craze came and went over the course of the past year, it was no secret that a common strategy employed by ICO projects was to introduce “utility” to make their token appear useful for something other than speculation, when the tokens were simply securities at the end of the day. And unsurprisingly, many centralized lending platforms partake in this strategy as well. Take Nexo for instance. On Nexo, all loans are 16% APR; but this is reduced to 8% APR if NEXO tokens are used as collateral or repayment for the loan. By denominating platform activity in NEXO tokens and forcing users like me to go out of my way to acquire NEXO in order to cut my interest payments by half, a severe bottleneck in my user experience is created. Additionally, by intermediating the loan process with their own token, NEXO is essentially making users tie their wealth up in a highly volatile token that can be used for just one thing. It’s like being forced to store my wealth in Air Miles or loyalty points as opposed to cold, hard cash which can be used anywhere.

Case study: SALT Lending
A notorious example of a token model gone wrong is SALT Lending. Despite significant initial excitement about the project back in 2017, the project failed to gain the traction it was expected to, as it fell victim to an unsustainable business model centred around the SALT token. Initially, one use case for SALT tokens was to be an alternative repayment method for loans taken out on the platform at a rate of $27.50 per token. However, when the price of token declined due to less-than-expected demand, it quickly became apparent that one could purchase SALT at a low price on an exchange, and use it to repay a loan that was much greater than its value (at times, loans that were more than 10x the value of the tokens used to repay).

When it seemed that this model was clearly not feasible, there was a stretch of several months in April — June 2018 where SALT nearly ceased all communications with the public through its social media channels. Upon the end of this period, SALT introduced widespread changes to its token model, including the removal of the $27.50 “peg” of the SALT token, moving instead to a dynamic pricing model where the SALT token price on the platform would vary with the market, as it should have in the first place. In one fell swoop, SALT completely altered the utility of its token, effectively changing the agreement it made with borrowers who had previously taken loans from the platform, not to mention early investors in their token.

So thanks but no thanks…

As you can probably tell, late rent payment or not, there was no way I could convince myself to lock my bitcoin into a centralized lending platform. Fortunately, they’re not the only solutions out there. Just as centralized exchanges paved the way for decentralized ones, centralized lending solutions mark just the beginning of the crypto-lending story. Are decentralized lending protocols like ETHLend and MakerDAO the solution? (Spoiler alert: not exactly…) Check out Part 2 where I’ll dive into the biggest improvements that decentralized lending solutions bring, but also discuss their own unique set of problems, which, of course, was ultimately why I was late on my rent payment.

Do the problems we highlight strike a chord with you? Are there other problems you see with decentralized loan platforms? Comment below!
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