(Bloomberg) --Crypto exchanges seeking to bolster sagging revenues are stepping up lending, potentially seeding the market with fresh risks less than a year after the last major crisis.
Recently launched programs from the likes of Coinbase Global Inc. and Binance come in many different guises, from margin loans meant to stimulate trading to facilitating borrowing through their platforms to making direct loans to clients.
Crypto lending is still small compared with the leverage bubble that took down large swathes of the sector when it burst in 2022, and executives say they've taken pains to avoid a repeat. Yet the comeback risks creating new opaque pockets of leverage across crypto markets that could exacerbate the impact of any major correction in prices.
A more urgent concern for exchanges may be that the initiatives are showing few signs of rekindling moribund trading.
"It could backfire on them for sure," said Hilary Allen, a professor at American University Washington College of Law who studies the impact of new technologies such as crypto on financial stability. "Any time you take an asset and lend it out, you are creating leverage and it creates fragility. I think the crypto industry in general is trying everything right now in a sort of existential struggle."
Aggregate data on lending by crypto exchanges isn't available. However, the past few months alone have seen several of them unveil new initiatives.
Fierce Competition
In August, Coinbase started letting institutional clients lend out their crypto to earn yields. A month earlier, smaller exchange Bitget began lending either fiat money or cryptocurrencies to users who put up their crypto as collateral. Industry giant Binance, which has suffered a steep drop in market share, has offered one-hour, zero-interest margin loans on several occasions. Other platforms like Bitstamp have also joined the fray.
The efforts underscore the ferocious competition for market share as trading volumes remain nearly 90% lower than they were when Sam Bankman-Fried's FTX went bust last November. Coinbase's third-quarter spot trading volumes fell more than 50% from a year earlier to the lowest since before its April 2021 initial public offering, according to estimates from CCData. Binance had an even bigger estimated decline of 64%.
To some extent, the 2022 unwinding of the lending bubble has contributed to exchanges' woes. Lenders like Celsius Network, BlockFi Inc. and Genesis, which stimulated activity by funneling billions of dollars of credit to traders, collapsed when tumbling prices laid bare flaws in their risk management.
Exchanges say they've learned lessons from last year's carnage. Some firms, like Coinbase, only facilitate loans that are fully backed by collateral. Others only accept stablecoins or major tokens like Bitcoin as backing, shunning smaller coins that are more volatile. Another method is working with third-party loan providers, which lets platforms avoid taking direct balance-sheet risk. Some exchanges say they collect detailed information on borrowers before allowing them to tap credit, and lenders have the right to refuse to lend to counterparties they're not comfortable with.
Jean-Baptiste Graftieaux, chief executive officer of Bitstamp, said the industry is adding more guardrails as it rolls out new lending initiatives.
Bitstamp works with five-year-old Tesseract, based in Finland, to facilitate lending by its customers to borrowers such as market makers. Tesseract says it only accepts collateral in Bitcoin, Ether and stablecoins — tokens that are pegged to an asset like the U.S. dollar — and stores it with third-party custodians.
Even with the safeguards, additional lending is adding a layer of opacity to a market prone to extreme volatility, some industry observers say. Since the exchanges typically don't publicly disclose how much they've lent, it's hard to gauge the impact on overall leverage in the system.
"The more you get complex positions tying up the market, the more risk and the less understanding of exposures people can have," said Toby Lewis, CEO of Novum Insights, a crypto analytics firm. "My gut [is] that it's still probably quite early, and actually the fact that people are beginning to take more risk in the short term is a little positive, but it then needs to be managed appropriately and not in the same way as it was in the past."
In equities trading, there are centralized clearing houses and standardized margin rules that govern settlement in case a borrower defaults. Crypto doesn't have central clearing houses and relies on collateral standards that vary between exchanges, making it harder to judge who's on the hook when a margin position blows up, said Larry Tabb, head of market structure research at Bloomberg Intelligence.
Swan, Wintermute Competition
By ramping up lending, exchanges also risk inviting scrutiny from regulators. The U.S. Securities and Exchange Commission, for instance, has signaled that it wants them to handle fewer functions. One aspect where crypto stands out from equities is that platforms like Binance handle a much greater variety of tasks than do stock exchanges — like holding assets in custody and supplying margin loans. That gives them additional profit drivers, but it can also serve to concentrate risks.
Ultimately, hanging over the industry is the question of whether the lending forays are worth the potential headaches. Competition is heating up as players from Swan Bitcoin to a Wintermute-supported project plan to enter the market, which could pressure margins.
As for the impact on trading, the data doesn't look promising. Total spot trading at the five largest crypto exchanges declined about 22% between the second and third quarter of this year, according to CCData.
"As long as the market remains downbeat even these promotional incentives may not really make much difference," said Anatoly Crachilov, CEO of London-based alternative investment manager Nickel Digital.
