Author: Emilios Avgouleas, Alexandros Seretakis Compiler: Wang Han

The collapse of Genesis is the latest in a string of failures by cryptocurrency lenders. Last year, many major cryptocurrency lenders collapsed in a domino-like fashion. These failures exposed the fragility of the cryptocurrency market lender’s business model, most notably liquidity and maturity mismatches in its loan portfolio, as well as its apparently weak corporate governance. This article explores pathways for regulating cryptocurrency lending within the EU financial services regulatory framework. It argued that cryptocurrency lenders should be deemed to meet the definition of a credit institution under EU law and, therefore, should be subject to the strict licensing and prudential requirements introduced by the Capital Requirements Directive and Regulation. The Institute of Financial Science and Technology of Renmin University of China compiled the core part of the research.

I. Introduction

One of the biggest challenges policymakers face regarding cryptocurrency markets is the handling of cryptocurrency loans. The President of the European Central Bank recently stated that the rising incidence of fraud, criminal transactions and questionable valuation practices in the field of cryptocurrency lending poses serious risks to consumers and that cryptocurrency loans should be regulated. One question that arises from her statement is: How should cryptocurrency lending be regulated?

This article will explore the avenues for regulating cryptocurrency lending within the EU financial services regulatory framework. It will argue that cryptocurrency lenders fall within the definition of a credit institution under EU law. They are therefore subject to strict licensing and prudential requirements under the Capital Requirements Directive and Regulations. It is important to note that the cryptocurrency lender operates primarily in the United States and still has limited presence in Europe. However, the substantial growth in crypto lending in Europe may lead crypto lending companies to expand their operations in Europe, thus requiring a regulatory response from European policymakers. A similar pattern can be observed with regard to the regulation of credit rating agencies. Although the three major credit rating agencies are all based in the United States, their expansion in Europe and their role in exacerbating or triggering financial and sovereign debt crises has forced European policymakers to adopt a comprehensive regulatory framework.

Cryptocurrency lending has grown exponentially over the past few years, with the failures of Celsium Network and Voyager alerting policymakers to the importance of crypto lenders to the cryptocurrency market and the fragility of their business models. Additionally, FTX’s stunning collapse caused contagion across the industry and had a spillover effect on cryptocurrency lenders, with major players such as Genesis and BlockFi suspending withdrawals of customer funds and filing for bankruptcy. As stated in this article, the activities of cryptocurrency lenders, including accepting deposits of cryptocurrency assets and issuing cryptocurrency loans, are similar to bank activities. However, the lack of regulation creates a competitive advantage for cryptocurrency lenders over licensed banks. Unregulated cryptocurrency lenders are able to generate returns by taking on excessive risk.

Furthermore, as the recent Celsius debacle illustrates, the procyclical nature of crypto lending activity, selling off of stocks held by investors in other asset classes, the high leverage employed, and the risk of a run on savers could trigger a system sexual risks. Prudential regulation will make cryptocurrency lending institutions safer and more stable. For example, prudential regulation could prevent cryptocurrency lenders from being exposed to a single asset class and could cure their vulnerability to liquidity risks (e.g., user runs). This will also limit the ability of cryptocurrency lenders to leverage heavily. In this way, cryptocurrency lenders will become more stable and resilient, and the recent series of failures will be avoided.

2. Decentralized Finance (DeFi) and Crypto Lending

2.1 Decentralized Finance/DeFi:

The combination of blockchain technology and smart contracts has given rise to a new form of financial ecosystem called decentralized finance, or DeFi. DeFi aims to replicate existing financial services without the involvement of central intermediaries. In a DeFi environment, users can maintain full control of their assets and interact with the ecosystem through peer-to-peer (P2P), decentralized applications (dapps). DeFi applications do not require any intermediaries or arbitrators. Preset guidelines provide for dispute resolution that can be predicted in advance. Essentially, the code is law between users, hence, in the context of the blockchain platform, it was named “Lex Cryptographica”. One of the purported advantages of DeFi is the bypass of rent-seeking intermediaries in financial services , and fosters an environment where technological innovation thrives, providing consumers with more choices in payments and lower transaction costs.

2.2 Nature of DeFi market:

The International Monetary Fund said the huge growth and expansion of the cryptocurrency market poses risks to financial stability. The recent turmoil in the cryptocurrency market, including the DeFi market, has exposed the structural fragility of the ecosystem. In particular, the chaos in the cryptocurrency market has exposed the volatility of crypto assets, with the cryptocurrency market witnessing wild price swings. Cryptocurrency assets exhibit greater extreme volatility than other financial assets. Furthermore, despite claims to the contrary, the correlation between changes in cryptocurrency asset prices and riskier assets such as stocks has been increasing over the past few years. Another major source of vulnerability is the ability of investors to establish highly leveraged positions, which exacerbates procyclicality and volatility and, like other forms of shadow banking, creates 25 invisible interconnections.

Much of today’s DeFi activity lies outside regulatory scope, and as a result, the European Commission recently proposed a digital finance package aimed at promoting European competitiveness and innovation in the financial sector. The package includes legislative proposals for a digital finance strategy, a retail payments strategy, crypto-assets and digital operational resilience, as well as a mapping regime for market infrastructure supported by distributed ledger technology. These are just the beginning, EU financial services regulation will soon require comprehensive reforms to keep pace with the digital transformation of financial value chains within the EU and globally.

2.3 Special Cases of Crypto Lending:

The sudden collapse of Celsius and Voyager has focused policymakers’ attention on the fragility of cryptocurrency lenders’ business models and their contribution to systemic risk. Cryptocurrency lenders, such as Celsius and Voyager, attempt to provide solutions to two different problems faced by cryptocurrency holders: lack of liquidity and lack of market purchasing power. Therefore, cryptocurrency holders who want to monetize their cryptocurrency holdings can convert them into fiat currency. Additionally, it offers them the opportunity to earn significant returns on their cryptocurrency holdings through staking, which is only available to holders of large portfolios. Specific cryptocurrency lenders engage in secured lending, allowing holders to deposit their assets and borrow fiat currency or other digital assets against their cryptocurrency holdings as collateral.

Celsius offers a so-called “Earn” program that allows users to deposit digital assets into Celsius, which can then be used to generate earnings. Users are rewarded for their assets in the form of in-kind interest or Celsius tokens, with annual yields reaching 17% on some assets. The company generates revenue through a variety of activities, including loan servicing, and also provides lending services to retail and institutional clients. In addition, the company has issued loans to customers secured by digital assets and allowed them to rehypothecate. Additionally, it participates in staking and deploys digital assets into automated market makers or lending protocols for fees. Losses on certain illiquid investments and the collapse of the cryptocurrency market led to massive withdrawals by savers, destabilizing the company, which was forced to ban withdrawals to stem the exodus of savers.

Voyager is the next major cryptocurrency lender to file for bankruptcy following turbulence in the cryptocurrency market and the default of one borrower. Voyager operates a cryptocurrency platform that enables its users to trade and store cryptocurrencies. Customers can deposit their cryptocurrency holdings and earn interest. Voyager can pay interest on deposits by lending cryptocurrencies deposited on its platform to third parties at pre-negotiated interest rates. Widespread panic in the cryptocurrency market, Celsius Network’s announcement to suspend all account withdrawals and transfers, and the collapse of crypto fund Three Arrows, which had lent more than $670 million, led to a run on Voyager’s customers. The company was forced to suspend withdrawals and trading activities on its platform and filed for bankruptcy.

Finally, cryptocurrency lenders were hit hard by the sudden collapse of cryptocurrency exchange FTX. FTX used customer funds to fund high-risk and illiquid bets at its affiliated trading firm Alameda Research, but failed to meet the requirements. The resulting liquidity crunch forced FTX to file for bankruptcy. The bankruptcy proceedings revealed aggressive risk-taking, a complete lack of corporate control and risk management, a lack of transparency and trustworthy financial information, and self-dealing.

3. Crypto Lending: Risks and Regulatory Responses

Key financial stability threats to cryptocurrency lending come from excessive volatility in the cryptocurrency market, as well as the fact that many cryptoassets, such as non-fungible tokens (NFTs), are complex and difficult to value, making it difficult to obtain sufficient collateral to secure a loan. Therefore, user leverage within the system remains uncontrolled. This practice creates doubts and rumors about the financial health of cryptocurrency lenders, triggering market panic, manifesting as a run on savers, exposing hidden liquidity imbalances within cryptocurrency lenders, and causing cryptocurrency exchanges to The platform faces the risk of insufficient liquidity. The activities of a cryptocurrency lender, including accepting deposits of cryptocurrency assets and issuing cryptocurrency loans, are similar to those of a credit institution. Under the Capital Requirements Regulation (CRR), a credit institution is defined as “an undertaking whose business is to accept deposits or other repayable funds from the public and to extend credit to its own accounts”. Credit institutions are subject to a strict licensing regime that builds on the prudential rules introduced by the Capital Requirements Directive (CRD) and the Capital Requirements Regulation. The rules apply to banks and investment firms and include strict capital requirements and liquidity requirements. In addition, prudential supervision under the Regulations extends to corporate governance provisions that are designed to ensure the independence and diversity of the board of directors and enhance risk management. System and control requirements will ensure cryptocurrency lenders are protected from the risk of cyberattacks. In addition, prudential rules impose limits on remuneration, which are designed to promote prudent risk-taking and ensure that remuneration policies are consistent with the long-term interests of the institution.

Cryptocurrency lenders that meet the definition of a credit institution need to be licensed under the Capital Requirements Directive and the criteria it sets out for the assessment of license applications. The ECB stated that when assessing applications for licenses involving crypto-asset activities and services, the ECB and national competent authorities must review how the proposed activities match the institution’s overall activities and risk profile and whether the institution’s policies and procedures are sufficient to identify and address Risks specific to crypto assets and whether senior management and board members have knowledge and experience in IT and crypto markets. The application of these licensing standards will ensure that only crypto lenders with sound business models and internal governance, as well as competent senior management, will be able to obtain licenses from credit agencies.

An additional benefit of the cryptocurrency lender licensing regime is that licensed institutions will also be subject to the MiFID II product governance regime, and as such, they will be required to disclose the historical volatility and default rates of their products to users, thus minimizing the risk of infringement of the true nature of the product. Any attempt to mislead investors regarding risks and maximize user/consumer protection. The product governance requirements introduced by MiFID II have proven to be one of the most important elements of the MiFID II investor protection framework and are designed to ensure that firms act in the best interests of their clients at all stages of the investment product life cycle and to prevent mis-selling. As part of the product governance requirements, end customer target markets must be identified and regularly reviewed for each product, and a distribution strategy must be developed that is consistent with the identified target markets. Furthermore, assuming that cryptocurrency loans can be used for money laundering activities, authorization will address this issue by default, as authorizing institutions will enforce “know your customer” (“KYC”) protection requirements for their clients.

IV. Conclusion

This article examines the mechanics of a key part of the cryptocurrency market. It also recommended that cryptocurrency lenders should be licensed and regulated as credit institutions under EU law to increase the stability of the cryptocurrency lending industry and create a level playing field with mainstream lenders such as banks. A closer look at recent failures shows that the industry is highly unstable and ripe for tough regulation, which would stabilize the industry, limit the risk of contagion from a run on savers, and prevent future bankruptcies.

It should be noted that Awrey and Macey also recommend a licensing regime for data aggregators in the context of open banking. But the authors' recommendations refer to controlling market forces, not promoting financial stability as currently proposed. A viable licensing alternative would be to systematically curb the promotion of cryptocurrency lending schemes by consumer protection regulators. Nonetheless, regulating cryptocurrency lending schemes from a consumer protection perspective may not be adequate to address the financial stability risks arising from their activities.

Arguably, a licensing regime for cryptocurrency lenders could spell the end of DeFi as an unregulated market segment. But the important thing to note here is that other parts of the cryptocurrency market, such as trading, will not be affected. Imposing prudential regulations on cryptocurrency lenders will certainly increase compliance burdens and costs, eroding cryptocurrency lenders’ profits.

However, the recent collapse of FTX shows that the business models and profits of many cryptocurrency companies are the result of regulatory arbitrage, weak corporate governance, excessive risk-taking and outright fraud. Furthermore, the unregulated nature of cryptocurrency lending provides cryptocurrency lenders an unfair advantage over regulated financial institutions such as banks, which are subject to strict prudential and business conduct rules. While there is no evidence that cryptocurrency lending brings any specific benefits, the level and type of risk (market failure) associated with this activity fully justifies intrusive regulation, and prudential regulation is the most effective way to control this activity tool.

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