How do Wall Street elites view the multi-billion dollar cryptocurrency lending market?

This article was published by Block Rhythm, original title: "What Does the Crypto Credit Market Look Like in the Eyes of Wall Street Elites?", Author: Peter Johnson, Head of Investments at Jump Capital, Translated by: 0x26

The author of this article, Peter Johnson, is the Head of Investments at Jump Capital. Since joining Jump Capital as its first employee in 2013, he has invested in over 50 companies, including many leading cryptocurrency firms. Jump Capital is part of Jump Trading Group, one of the largest private trading firms in both traditional and crypto markets.

After reading this article, the translator felt the continuous evolution of the crypto market and the existing degree of disconnection among retail investors, miners, developers, trading platforms, market makers, and professional financial service institutions. This article not only outlines the development of the crypto credit market but also explains, to some extent, the reasons behind the massive issuance of stablecoins and the influx of WBTC into the DeFi market.

Looking across the entire industry, regardless of the angle from which you approach the market, it is undeniable that the crypto market has matured significantly. We are no longer in the era of "100x leverage," where there are not only passionate Hodlers holding onto their ideals but also Suits from traditional finance striving for a mere 0.1% interest margin.

In recent years, the crypto credit market has experienced exponential growth, with assets on the BlockFi platform reaching $15 billion, Genesis creating $7.6 billion in loans in the fourth quarter of 2020, and Compound's current loan volume reaching $5 billion. At Jump Capital, we believe that the crypto credit market will continue to expand rapidly, and the next generation of iconic global financial systems will be built on the crypto market.

We are also honored to be investors in several innovators in this field, including BlockFi, Voyager, BitGo, Zipmex, and CoinDCX. In this three-part article, we describe why the crypto credit market offers high interest rates (compared to traditional financial markets), attracting billions of dollars in deposits, who the main participants are, and how we expect this market to evolve over time.

Part One: How Do BlockFi and Voyager Maintain Annual Interest Rates Above 8%?

Almost every day, we receive messages from friends inquiring about the savings rates offered by companies like BlockFi and Voyager. These annual interest rates are typically over 8% for USD (in cryptocurrency) and over 5% for Bitcoin, which is incredible in a real world where the average savings account yield is 0.05%. By the way, if you haven't heard, you can indeed earn over 8% annualized interest from these platforms.

Unsurprisingly, these high yields attract a large number of customers and assets. To understand how these yields are achieved, we must understand who is willing to borrow at such rates.

If deposits can earn over 8% interest, then there must be someone willing to pay at least 8% (plus some spread) to borrow that capital. Who is willing to pay such high rates? In fact, there is indeed a segment of this group, particularly:

• Traders

• Retail borrowers with special needs

• Companies within the crypto industry

Traders are undoubtedly the largest borrowers in the crypto credit market. They borrow at such high rates because they believe they can achieve returns from trading activities that exceed the interest costs. Some of the ways traders achieve these returns come from leveraging reliable strategies that exploit market inefficiencies, while others are more speculative in nature. Traders represent a huge demand side in the crypto credit market because:

• Unique markets create significant profit opportunities;

• The crypto market requires substantial funds due to the need for pre-deposits on trading platforms;

• Traditional financial institutions typically do not lend to cryptocurrency traders.

We refer to the three most notable types of trades in this category as basis trading, cross-exchange arbitrage, and grayscale trading.

Basis trading exploits the industry phenomenon where the trading price of Bitcoin (and other crypto assets) futures is often much higher than the spot price (similar situations exist for other crypto assets). This trading model specifically manifests as traders buying spot and selling futures, capturing the difference between the futures and spot prices at expiration.

Cross-exchange arbitrage is a simple arbitrage based on price differences between trading platforms. For example, if Bitcoin is trading at $50,000 on Coinbase and $50,005 on Bitstamp, a trader would buy on Coinbase and sell on Bitstamp, netting a risk-free $5 (minus transaction fees). A few years ago, price discrepancies between trading platforms were common. Today, as the market has evolved, the returns from ordinary arbitrage trades rarely exceed transaction fees, so such trading opportunities are diminishing.

Grayscale trading takes advantage of the premium on trusts like Grayscale Bitcoin Trust (GBTC) over their net asset value (NAV), which often (or at least used to) trade at a premium to the spot. This trading dynamic applies not only to GBTC but also to Grayscale trusts for Ethereum, Litecoin, and large-cap indices, as well as trust products created by Bitwise and other companies. In this trade (using GBTC as an example), traders borrow Bitcoin, use that Bitcoin to create GBTC at its NAV, wait for six months until GBTC can be sold on the open market, and then sell GBTC to capture the premium.

These arbitrage trades exist primarily due to investment access issues. Many investors want exposure to crypto assets but cannot or do not want to hold the assets directly. For example, many individual investors wish to invest in crypto assets from their traditional brokerage or IRA accounts, and many institutional investors are restricted by investment mandates to only invest in products traded on traditional mature exchanges with CUSIP*. These investor groups are limited to products like CME Bitcoin futures and GBTC. Due to the high demand for these products, their trading prices often exceed the prices of the underlying assets. This creates arbitrage opportunities for traders—leading to a demand for funding—so traders are willing to pay high interest rates to finance these trades.

Note: CUSIP (Committee on Uniform Securities Identification Procedures) Number is a unique identifier for all stocks and registered bonds, managed by the Committee on Uniform Securities Identification Procedures. This system is used in the United States and Canada.

Another type of trading is speculative trading, where traders use leverage to become net long or net short in the market.

For investors looking to amplify returns (and losses), using leverage is one way. Leverage can come from borrowing from third-party lending institutions or using margin to borrow on trading platforms. Currently, a significant portion of the crypto credit market ultimately fuels leveraged trading, including most lending on decentralized lending protocols like Compound and Aave. As the saying goes, "leverage is poison"—and the cryptocurrency market can sometimes become extremely destructive due to leverage (the original text refers to it as 'Scarface', the action movie starring Al Pacino). We expect that the crypto market will continue to experience bull markets, leverage will continue to increase, and the scenes will remain spectacular; of course, large-scale consecutive liquidations will inevitably impact the high-leverage market.

Another speculative trading scenario is short selling. The classic method of shorting an asset is to borrow the asset, sell it in the market, wait for the asset to drop, buy it back, and then repay the loan. Some traders still have enough courage to short in today's market, and we can only wish them good luck.

This leads us to the second reason why traders have a strong demand for borrowing cryptocurrencies—crypto trading can require substantial funds. This is because crypto trading platforms require pre-funding, and there are hundreds of trading platforms across the industry. For market makers and traders who need to trade across platforms to exploit price differences or achieve best execution, the need for pre-funding on trading platforms is particularly pronounced. This means that every trading platform where they wish to trade requires both coins and cash, which may seem normal to retail investors but is not the case in traditional markets. In traditional markets, traders only need to have funds at their primary brokerage, and they can trade those funds in many places.

Let’s introduce a very simplified example: suppose a trader wants to buy or sell $1 million worth of assets instantly across multiple trading platforms. In traditional markets, the trader would fund their primary broker with $1 million and could trade directly across multiple trading platforms (in fact, brokers are likely to provide leverage, so the trader may not even need to fully fund the $1 million). In contrast, in the crypto market, if a trader wants to instantly buy or sell $1 million worth of Bitcoin across 10 trading platforms, they need to fund each of those 10 exchanges with $1 million in cash and $1 million worth of Bitcoin, resulting in an upfront capital requirement of $2 million. In this example, the capital demand in the crypto market is at least 20 times that of traditional markets.

This brings us to the final reason why traders are the primary borrowers of crypto assets—this market lacks the quality services found in traditional finance. In the example above, the issue in the crypto market is not only the need for pre-funding on trading platforms but also the absence of major brokers stepping in to provide pre-financing and leverage for traders. For years, banks have avoided servicing crypto companies due to regulatory issues stemming from real or perceived biases. This bias still exists today, with a few notable exceptions like Silvergate and Signature. Because traditional banks are not interested in lending to crypto traders (except for some of the largest market makers), there is a significant borrowing demand from traders for crypto lending institutions.

As mentioned above, traders are not the only borrowers in the crypto market. Other borrowers include retail investors and crypto companies.

Retail investors may intend to make large expenditures, such as purchasing a home, but want to avoid the tax consequences of realizing gains. In this case, borrowing against their held cryptocurrencies can provide significant tax advantages compared to selling their holdings.

Another type of borrower is crypto companies. These businesses may need to borrow for capital expenditures (like mining companies) or simply borrow to facilitate growth. The crypto credit market can provide the necessary funding for these companies.

In summary, BlockFi, Voyager, and similar companies can pay high asset yields because there are borrowers willing to pay high yields. These borrowers include traders, individuals, and crypto companies, with traders being the largest segment in this market. These traders are willing to pay high interest rates for their borrowing because they deploy these funds into arbitrage and speculative strategies to earn high returns. The crypto market is a highly capital-intensive market, but these traders do not receive quality services from traditional lenders.

Part Two: Participants in the Crypto Credit Market

Now that we understand the drivers behind the high interest rates and growth in the cryptocurrency credit market, let’s take a look at who the "big players" are. The market chart below lists the categories of companies and key participants. Notably, we have excluded actual lenders/depositors and end borrowers, focusing instead on the intermediaries and technology providers that enable this market.

The main participants in this market include:

Crypto Asset Native Savings and Loan Companies

When we refer to these companies as "savings and loans," we use the term in its most literal sense (without any regulatory connotation), meaning these companies provide interest-bearing savings accounts for crypto assets and lend these assets out to earn returns. These companies typically start with crypto loans and interest-bearing accounts for retail investors. Some companies, like BlockFi, have also expanded into trading, payments, and institutional lending.

Economists Providing Interest-Bearing Accounts

Companies that started as crypto brokers/trading platforms and added interest-bearing accounts to their products.

Non-Native Crypto Interest-Bearing Accounts

Some companies provide high rates by lending to the crypto space (directly or through lending protocols) but are pulling crypto business away from users to attract a broader audience.

DeFi Protocols

Peer-to-peer smart contract lending protocols.

DeFi Interfaces

Third-party interfaces that allow people to interact with DeFi lending protocols (and other DeFi protocols).

Leverage Trading Platforms

Trading platforms that enable depositors (lenders) to earn returns by providing margin loans to traders.

Leverage Lending Bots

Automated systems that deploy funds into margin loans on trading platforms to optimize returns.

Institutional Intermediaries

Focusing on serving institutional clients to meet their lending/interest-earning needs. This includes companies like Genesis that are purely focused on lending, as well as custodians like BitGo that offer lending products, and innovative banks serving the crypto ecosystem—such as Seba and Sygnum, as well as companies with interest-bearing accounts—like Circle.

Lending Technology Providers

Companies providing technology to other crypto lenders.

Traditional Banks

Actively taking deposits from crypto companies and providing loans to them.

At Jump Capital, we have been active investors in several of these categories, including crypto asset native savings and loan institutions (BlockFi), brokers with interest-bearing accounts (Voyager, CoinDCX, Zipmex), and institutional intermediaries (BitGo).

Looking ahead, we will continue to be interested in making more investments in these categories and investing in other areas, including lending technology and DeFi protocol lending interfaces.

We are optimistic about crypto-native savings and loan companies like BlockFi because these companies are leading in attracting a large number of customers and assets with their interest-bearing accounts and have often developed substantial lending businesses with strong risk management practices. We believe that some of these companies have unique advantages that could make them the leading global financial institutions of the next era.

In the category of brokers with interest-bearing accounts, we seek to invest in the best fiat/cryptocurrency businesses that are on the rise globally. We plan to continue investing in the best trading platforms/brokers in major regions around the world and work with these companies to add interest-bearing accounts if they do not already offer such products.

Institutional intermediaries are attractive because we believe many providers of interest-bearing accounts will not build complete lending businesses to generate yields. Most will leverage intermediaries that specialize in lending and generating yields.

Non-crypto interest-bearing accounts are interesting because they expand the range of customers who can benefit from the high rates in the crypto credit market. While other crypto yield accounts primarily target customers who have adapted to crypto technology, these companies aim at a larger non-crypto market.

Lending technology providers are rapidly evolving, and now nearly every company in this space is building its own lending and interest-bearing account technology. Third-party technology providers have significant opportunities to establish top-notch software for a large number of companies to quickly enter this field.

Finally, we are interested in DeFi lending interfaces because DeFi protocols are increasingly accessed through the best interfaces, which provide portfolio management, trading, lending, yield, transfers, and more.

Overall, we believe there are significant opportunities within the entire crypto credit ecosystem and are excited to continue investing in these areas.

Part Three: The Future of Crypto Credit

When we invest in the crypto credit market at Jump Capital, one key question we consider is: how will this market evolve in the coming years? Specifically, we are thinking about what will happen when the current inefficiencies in the crypto trading market are corrected? How and when will interest rates in the market decline, and when they do, will the market's attractiveness to depositors/lenders diminish?

Over time, we believe that many inefficiencies in the crypto trading market will be corrected, and interest rates will decline. However, we expect that the demand for borrowing in the crypto credit market will continue to expand sharply, and the rates available to depositors will remain very attractive.

We are confident in the continued growth of the crypto credit market for several reasons:

• The crypto trading market is still in its infancy, and as trading market efficiencies improve, the growth of this market will be sufficient to offset any decline in borrowing demand.

• The crypto credit market has structural advantages compared to traditional credit markets, which will attract a large number of non-trading use case borrowers.

The first reason is straightforward—crypto trading is still a relatively small market. The field is still dominated by retail traders and a few innovative trading firms, consisting mainly of early supporters and users. There are few institutional traders entering the market. If the market develops as we believe it will—Bitcoin will be an asset in most investors' portfolios, crypto dollars will represent a new global flow of funds, and DeFi will provide a new way for the world to access financial services—then the crypto trading market will experience exponential growth in the coming years. This exponential growth will stimulate borrowing demand, making the reduced borrowing from the trading market more effective.

The second reason is even more important—the crypto credit market has structural advantages over traditional credit markets. These structural advantages include:

The crypto credit market is extremely flat. This market has achieved global connectivity, eliminating traditional intermediaries, allowing funds to flow freely from those with capital seeking to earn returns to those in need of funds willing to pay yields. In this market, depositors' funds can seamlessly flow to borrowers on the other side of the world without needing to go through a network of intermediaries as in traditional markets. In extreme cases, if both depositors and borrowers are directly using decentralized lending protocols, there is no need for any company or intermediary to facilitate the transaction.

Cryptocurrencies are nearly perfect collateral. For global lending operations, cryptocurrencies can serve as ideal collateral. They can be transferred instantly if needed, held directly, or custodied in smart contracts, and can be sold immediately in highly liquid markets if necessary. The biggest drawback of crypto collateral is its price volatility, which has already been mitigated by crypto dollars. For this reason, we expect that crypto collateralized loans will continue to experience explosive growth in the coming years.

In the crypto credit market, anyone can hold, earn interest, and borrow dollars. The global demand for dollars and dollar-denominated debt is insatiable, as evidenced by the fact that the dollar credit market for non-bank borrowers outside the U.S. is already a $12 trillion market, growing at 6% annually. This market is currently limited to governments and large institutions. Crypto dollars and crypto-based credit open this market to everyone around the world.

These structural advantages have allowed BlockFi and Compound to build multi-billion dollar lending businesses globally in less than five years. In the coming years, we expect these advantages to enable the crypto credit market to capture a significant share from traditional lending markets.

Some of the market's expansion will come from current use cases of crypto trading, personal crypto owners borrowing to purchase, and crypto companies borrowing to fund growth. However, these will not be the largest growth segments. The largest segment of expansion in the crypto credit market will come from non-crypto companies and individuals with borrowing needs, who may not even realize that crypto technology is being used on the backend to meet those needs.

In the future, many users who utilize cryptocurrency technology on the backend will become obscured. Users will deposit their savings into interest-bearing accounts on their favorite fintech applications, while companies will place their cash in interest-bearing corporate accounts. On the backend, these cash deposits will be converted into USDC and directly lent out around the world or deployed into DeFi lending protocols, with funds flowing to borrowers anywhere. These borrowers will be individuals borrowing from their favorite fintech applications or companies borrowing from next-generation enterprise lenders that have integrated into the crypto ecosystem. Both lenders and borrowers will not need to consider the various details that facilitate the transaction.

In many markets, speculation has paved the way for long-term technological evolution. In the crypto credit market, lending transactions and the initial use cases that exploit market inefficiencies have allowed new financial institutions to scale and established a new global financial system. This new global financial system will far exceed the transactions and crypto users that initially created and developed it.