Jump Capital Partner: Analyze the structure and development trend of crypto credit market participants


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Why can the crypto credit market provide an annualized savings interest rate of more than 8%? Who are the main participants?

Written by: Peter Johnson, Partner, Jump Capital Compiler: Perry Wang

In the past few years, the cryptocurrency credit market has grown exponentially, with assets on the BlockFi platform exceeding US$15 billion, Genesis providing US$7.6 billion in loans in the fourth quarter of 2020 alone, and the outstanding debt in the Compound agreement Services reached more than 5 billion U.S. dollars. At Jump Capital, we believe that the cryptocurrency credit market will continue to expand rapidly, and a new generation of iconic global financial institutions will be born on the crypto track.

We are honored to be a behind-the-scenes investor in many innovative projects in the crypto space, including BlockFi, Voyager, BitGo, Zipmex and CoinDCX. This article is composed of three parts, in which we describe why the crypto credit market is able to provide high interest rates to attract billions of dollars in deposits, who are the main players, and how we think the market will develop over time .

Part 1: How can BlockFi and Voyager pay depositors an annualized savings interest rate of more than 8%?

Almost every day we receive messages from friends asking us about the savings rates of companies such as BlockFi and Voyager. These interest rates are usually over 8% per year in U.S. dollars (crypto dollars) and over 5% in Bitcoin, which seems unbelievable in a world like the United States where the average savings account’s annual interest rate is only 0.05%. You heard that right, you have a chance to have a USD deposit with an annualized interest rate of more than 8%.

Not surprisingly, these high-yield savings products attract a large number of customers and assets. To understand how to obtain these benefits, we must understand who is willing to borrow at such a high interest rate.

If someone can earn an interest rate of more than 8% by saving, someone must borrow at an interest rate of at least 8% (plus part of the spread). Who is willing to pay such a high loan interest rate? There are several parties involved, especially:

  • trader
  • Retail lender
  • Encrypted Enterprise

Traders are undoubtedly the largest lenders in the crypto credit market. The reason why they borrow at this higher interest rate is because they believe that they can get a higher return from trading activities compared to the interest paid by the transaction. Part of the way for traders to obtain these high returns comes from time-tested and effective strategies that make full use of market inefficiencies, while other trading methods are more speculative. Traders are huge lenders in the cryptocurrency credit market because:

  • Unique market trends create huge profit opportunities
  • Since prepaid funds are required for trading on exchanges, the crypto market is extremely capital intensive
  • Traditional financial institutions usually do not provide loans to crypto traders

To further subdivide, there are mainly two types of investment strategy traders borrowing loans.

One type of transaction is an “arbitrage” transaction, based on market inefficiencies or dynamic changes in the market structure that create positive expected returns for traders.

The three most familiar trading methods in this category are “basis trading”, “cross-exchange arbitrage” and “Grayscale Trade”.

Basis trading takes advantage of the fact that Bitcoin (and other encrypted assets) futures are usually traded at a price much higher than the spot price of Bitcoin (and other encrypted assets). In this type of transaction, the trader buys spot and sells futures, and captures the difference between these prices when the futures expire.

Cross-exchange arbitrage is a simple arbitrage that uses price differences between exchanges. For example, if the transaction price of Bitcoin on Coinbase is $50,000 and the transaction price on Bitstamp is $50,005, the trader will buy Bitcoin on Coinbase and conduct a sell transaction on Bitstamp, thus making a net profit. The risk is $5 (minus transaction fees). A few years ago, price differences between exchanges were widespread. Nowadays, the price difference in cross-exchange transactions rarely exceeds the transaction fees, and the opportunities for such transactions are thus greatly reduced.

Grayscale trading can take advantage of the fact that trust products (such as Grayscale Bitcoin Trust [GBTC]) are often (or at least previously) traded at a premium to the net asset value (NAV). This trading strategy is not only applicable to GBTC, but also applicable to trust products launched by Grayscale for ETH, Litecoin, and large market capitalization digital asset indices, as well as trust products created by Bitwise and other companies. In this type of transaction (take GBTC as an example), a trader borrows bitcoin, uses the bitcoin to buy physical units of GBTC at NAV price, waits 6 months until GBTC can be sold on the open market, and then sells GBTC To harvest a premium. The recent trading price of GBTC has fallen below its net asset value, which means that this particular product has fewer opportunities for such transactions, but for traders who firmly believe that GBTC will eventually be converted to ETF and traded in NAV (we do this) Brings new opportunities. For more complex products, such as the Bitwise 10 index fund, the premium of its trading price relative to the net asset value also persists.

The existence of these arbitrage transactions is largely due to the access problem of crypto investment. Many investors want to obtain crypto assets, but are unable or unwilling to directly hold assets. For example, many retail investors want to invest in cryptocurrencies through their traditional brokerage accounts or individual retirement accounts (IRAs), while many institutional investors are restricted by their investment regulations and can only trade on traditional exchanges with CUSIP numbers. This group of investors is limited to investing in products such as CME Bitcoin futures and GBTC. Due to the high demand for these products, their transaction prices are usually higher than the prices of the underlying assets. This provides traders with an opportunity for arbitrage-this type of arbitrage transaction generates a demand for funds, so traders are willing to pay high interest rates to finance these transactions.
Another type of trading is speculative trading, in which traders use leverage to buy long or short positions in the market.

Investors want to amplify their gains (and losses), using leverage is one way. Leverage may come from the borrowing of third-party lenders, or it may come from financing transactions provided by exchange platforms that use margin. The current large-scale crypto-credit market has finally facilitated leveraged transactions, and loans including most decentralized loan agreements are also used for this purpose, such as Compound and Aave. As the saying goes, “leverage is a drug that you can’t get rid of”-sometimes this use case in the crypto market is filled with too many Scarface. We expect that the crypto market will continue to experience a wave of increased leverage, which will lead to some amazing price increases, and when waterfall liquidation inevitably impacts the over-leveraged market, there will be more thrilling selling frenzy.

Another speculative trading use case is shorting. The classic method of shorting an asset is to borrow the asset and sell it to the market, and then buy it back when its price drops to repay the loan. Some traders dare to go short in the face of current market conditions. Let the Lord bless these poor souls.

This brings us to the second reason, that is, traders are the main lenders of cryptocurrencies-cryptocurrency transactions are extremely fund-intensive. This is because cryptocurrency exchanges require pre-funding, and there are hundreds of trading venues on the market. For market makers and traders who need to cross-bank transactions to take advantage of the spread or the best execution price, the problem of pre-injection of capital on the exchange is particularly prominent. For every exchange you want to participate in trading, you need to invest in tokens and cash first. This seems to be normal for retail traders, which is not the case in traditional financial markets. In the traditional market, traders only need to have capital in their prime brokerage agency, and they can use this capital to trade in many trading venues.

To give a very simple example, suppose a trader wants to be able to instantly buy or sell $1 million in assets across multiple exchanges. In the traditional financial market, traders will inject 1 million US dollars into their prime brokerage institution and have the ability to trade on many exchanges (in reality, the prime brokerage institution may provide leverage, so traders do not even need to fully inject 1 million in the early period) US dollars). In contrast, in the cryptocurrency market, if traders want to be able to buy and sell US$1 million in Bitcoin instantly on 10 exchanges, they need to raise US$1 million from each of these 10 exchanges. Cash and 1 million US dollars of Bitcoin, its prepayment funding requirements are as high as 20 million US dollars. In this example, the capital intensity of the crypto market is at least 20 times that of the traditional market.

This leads us to the last reason why crypto traders are large crypto borrowers-traditional financial institutions cannot serve this market well. In the above example, the problem with the crypto market is not only that the exchange requires pre-funding, but also that there is no prime brokerage institution to intervene to provide traders with pre-funding and/or leverage. Over the years, banks have avoided serving crypto companies due to actual and perceptible regulatory issues. This prejudice still exists today, but there are some notable exceptions, such as the two banks Silvergate and Signature. Since traditional banks are not interested in providing loans to cryptocurrency traders (perhaps not the largest market makers), these traders rely on crypto lenders to meet their very important loan needs.

As mentioned earlier, traders are not the only lenders in the crypto market. Other lenders include retail lenders and crypto companies.

Retail lenders often borrow from the encrypted credit market, in addition to trading, they will also be used to purchase high-priced goods themselves. It is usually individuals who buy houses and other behaviors, and they prefer to obtain greater benefits through tax avoidance and other means. In this case, compared with the sale of encrypted assets, borrowing loans with the rights of cryptocurrency held by them is very advantageous in terms of taxation.

Another type of lender is an encrypted company . These companies need to borrow loans for capital expenditures, such as mining companies, or sometimes just borrow loans to promote business development. The crypto credit market can provide these companies with the funds they need.

In short, BlockFi, Voyager and similar companies can pay high interest rates for depositors’ assets because there are lenders who are willing to pay high interest rates to obtain loans. These lenders are traders, individuals and crypto companies, and traders have the highest share of the market. These traders are willing to pay high interest rates for their loans because they invest these funds in arbitrage and speculation strategies to obtain high returns. The crypto market is very capital intensive, and these traders cannot get the good services of traditional lending institutions.

Part Two: Participants in the Crypto Credit Market

Now that we understand the driving force behind the high interest rates and growth of savings in the crypto-credit market, let’s take a look at who the main players are. The following market chart lists the categories of relevant companies and major players. We excluded actual lenders/depositors and ultimate lenders, and instead focused on intermediaries and technology providers in this market.

The main players in this market include:

Crypto-native savings and loans

When referring to the activities of these companies as “savings and loans,” we use the term as literally as possible (without any regulatory or regulatory meaning), because these companies provide interest-bearing savings accounts for encrypted assets and transfer these Loan assets to earn income. These companies usually started by providing crypto-backed loans and interest-bearing accounts for retail investors. Some of these companies, such as BlockFi, have expanded into the fields of transactions, payments, and institutional loans/borrowing.

Institutions that provide brokerage business with interest-bearing accounts

A company that started as an encrypted brokerage institution/exchange and added interest-bearing accounts to its products.

Encrypted abstract interest-bearing account

Companies that provide depositors with high interest rates by providing loans to the cryptocurrency field (directly or through DeFi lending agreements), but are abstracting the cryptographic part of the business and not appearing in the user’s field of vision in order to attract a wider audience.

DeFi loan agreement

Facilitate smart contract agreements for P2P loans/lending.

DeFi lending / loan interface

The third-party interactive interface allows people to interact with DeFi lending agreements (and other DeFi agreements).

Exchanges that provide P2P leveraged loans

An exchange that enables depositors/lenders to earn interest by providing leveraged loans to traders on its trading platform.

Leveraged loan robot

Automate leveraged loans in exchanges to optimize returns.

Agency intermediary

Focus on providing services to institutional clients to meet their borrowing/making money needs, including companies like Genesis that are purely focused on borrowing/lending, and custodians that provide borrowing/lending products, such as BitGo, serving the innovation of the crypto ecosystem Type banks (such as Seba and Sygnum) and companies with interest-bearing public accounts (such as Circle).

Loan technology

A company that provides technology for other crypto lending companies.

Traditional bank

Banks that actively take deposits from crypto companies and provide loans for them.

At Jump Capital, we actively invest in several of these categories, including crypto-native savings and loans (BlockFi), agencies that provide brokerage services in interest-bearing accounts (Voyager, CoinDCX, Zipmex), and agency intermediaries (BitGo).

Looking ahead, we are still very interested in investing more in these categories and investing in other areas, including cryptographic abstraction of interest-bearing accounts, lending technology and DeFi lending interface.

We are very optimistic about crypto-native savings and lending institutions such as BlockFi, because these companies have a leading advantage in attracting a large number of customers and assets by using their interest-bearing accounts, and they usually develop influential loan businesses through strong risk management practices. . We believe that some of these companies have the unique conditions to become a new generation of leading global financial institutions.

In the category of institutions that provide brokerage services with interest-bearing accounts, we seek to invest in the world’s best legal currency/encrypted entry ramp. We plan to continue to invest in the best exchanges/brokers in every major region of the world. If they have not yet provided this product, we will cooperate with these companies to add interest-bearing account services.

The institutional intermediary category is very attractive because we believe that many interest-bearing account providers will not build a complete lending business to generate revenue. Most will use intermediaries that specialize in borrowing/lending/generating income.

The cryptographic abstraction of interest-bearing accounts is interesting because it expands the range of customers who can benefit from the high savings rates of crypto credit. Other encrypted accounts with interest are mainly aimed at customers who are familiar with encrypted currencies, but these companies are aimed at the broader market of non-crypto groups.

Lending technology providers have great investment potential, because almost all companies in this field are currently building their own lending and interest-bearing account technology. For third-party technology providers, this is a huge opportunity to create the best software that can be adopted by a large number of new companies.

Finally, we are still very interested in the DeFi lending and lending interactive interface, because through the best interactive interface, you can access more and more DeFi protocols, which can provide portfolio management, trading, lending, interest earning, transfers and other services.

Overall, we believe that the entire crypto credit ecosystem is full of major opportunities, and we are happy to continue investing in these categories.

Part Three: The Future of Crypto Credit

While Jump Capital continues to invest in the crypto credit market, one of the key issues we consider is how the market will develop in the next few years. Specifically, we doubt what will happen as the current inefficiencies in the crypto trading market are gradually corrected. When will market interest rates go down, and when will they go down. If it declines, will the market’s attractiveness to depositors/lenders decrease?

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

We are confident in the continued growth of the cryptocurrency credit market for two main reasons:

  • The crypto trading market is still in its infancy. As the efficiency of the trading market improves, the growth of the market will be sufficient to offset the decline in loan demand.
  • The encrypted credit market has structural advantages over traditional credit markets and will attract a large number of non-transactional lending use cases.

The first reason is simple-crypto trading is still a relatively small market. It is mainly an area where retail investors and some innovative trading institutions are active in early adopters of cryptocurrency. Institutional traders are rarely seen in the market. If the market develops in the way we envisioned-Bitcoin becomes an asset in the portfolio of most investors, the crypto dollar is the new track of the global currency movement, and DeFi provides the world with a new way to obtain financial services, then crypto trading The market will grow exponentially in the next few years. This exponential growth will greatly contribute to the demand for borrowing, and the decline in borrowing due to the improvement of capital efficiency in the trading market will be insignificant by comparison.

The second reason is more important-the encrypted credit market has a structural advantage over the traditional credit market. These structural advantages include:

  • The cryptocurrency credit market is extremely stable. The market is interconnected on a global scale, eliminating traditional intermediaries and allowing capital to flow freely from all those who want to earn income to those who need it and are willing to pay for the income. In this market, depositors’ capital can flow seamlessly to lenders on the other side of the world without going through an intermediary network like traditional markets. In extreme cases, if both depositors and lenders directly use decentralized loan agreements, there is no need for any company or intermediary in the transaction.
  • Crypto assets are almost perfect collateral. For the global loan business, cryptocurrency may be the ideal collateral. It can be transferred immediately, directly held, and hosted in a smart contract as needed, and it can be sold to a highly liquid market immediately as needed. The biggest disadvantage of crypto collateral is that its price is volatile, and even this can be overcome with crypto dollars. Therefore, we expect that encrypted mortgage loans will continue to show explosive growth in the next few years.
  • In the crypto-credit market, anyone can hold and borrow U.S. dollars and use them to earn interest. The global demand for U.S. dollars and U.S. dollar-denominated debt is infinitely satisfying, and facts show that the size of the U.S. dollar credit market provided to non-bank lenders outside the United States has reached 12.2 trillion U.S. dollars and is growing at a rate of 6% per year. Participants in this market are currently limited to governments and large institutions. Crypto-dollars and crypto-based credit markets are open to everyone in the world.

These structural advantages have allowed BlockFi and Compound to establish a global multi-billion dollar loan business in less than five years. In the next few years, we expect that these advantages will enable the crypto-credit market to steal a considerable market share from the traditional loan market.

Part of the expansion of this market will come from current use cases for crypto transactions, retail cryptocurrency holder loans for purchases, and crypto companies funding growth through loans. However, these will no longer be the most important part of the market’s growth. The largest share of the expansion of the crypto credit market will come from non-crypto companies and individuals with loan needs. They may not even know that the back-end uses encrypted assets to meet these borrowing needs.

In the future, many end users will not be aware of the use of cryptocurrency at the back end of the transaction. Individuals deposit their savings in interest-bearing accounts in their favorite financial technology applications, while companies deposit their cash in interest-bearing public accounts. At the back end, these cash deposits will be converted into USDC and directly loaned globally, or deployed into DeFi lending agreements, in which funds can flow to lenders anywhere. These lenders will borrow from their favorite fintech applications or borrow from a new generation of corporate loan service agencies that have been inserted into the crypto ecosystem. Neither lenders nor borrowers need to consider the crypto track that facilitated the transaction.

In many markets, speculative trading paves the way for long-term technical plans. In the encrypted credit market, the use of loans for transactions and the exploitation of inefficient primary use cases in the market can enable brand-new financial institutions to achieve scale and establish a new global financial system. The coverage of this new global financial system is by no means limited to crypto traders and users.

Source link: jumpcap.com