Over the course of the pandemic alone, the total market cap for cryptocurrency has increased from approximately $150 billion to $2.5 trillion. Looking forward, the market is expected to grow at a compounded annual growth rate of 60.8% between 2021-2026. Regardless of whether you believe in the widespread adoption of cryptocurrency as a form of money, the immense growth of the crypto marketplace reflects a permanence for crypto as a type of financial asset that’s going to continue to interest people in the years to come.
However, despite the crypto markets’ bullish behavior, crypto-asset holders’ spending power is still relatively limited. This limitation exists in part because: (1) there are few ways to spend crypto on real world goods and services, and (2) crypto-asset holders would rather hold on to their crypto-assets in the hopes that they continue to appreciate in value. The overall result of this strategy is that the value of crypto is not leveraged like other financial assets and remains locked in the wallets of the crypto holders.
What is Crypto Lending?
Crypto lending involves a lender loaning fiat money to a crypto-owning borrower and securing said loan by taking a security interest over the borrower’s crypto assets. In this relationship, the lender often exercises control over the crypto assets, holding them as collateral until the loan is repaid or the crypto assets are liquidated. Repayment of the loan in a centralized crypto lending relationship, between a traditional financial institution and a borrower is often made in cash installments over the course of a term set out in the loan agreement. If a borrower fails to repay the loan, the lender may liquidate the crypto assets under its control in an effort to recoup the loan amount they provided. The centralized crypto lending relationship, otherwise known as the Ce-Fi model, differs from decentralized, or peer to peer lending solutions that fall within the realm of decentralized finance (De-Fi). In De-Fi lending arrangements, money is typically pooled by participant lenders in an application governed by code (i.e. smart contracts), which is used to generate crypto loans, automate payouts and create lender yields for certain participants.
Either arrangement enables the borrower to monetize and leverage its crypto assets, providing them with liquidity without requiring them to sell off their underlying crypto assets. At the same time the lender is able to generate additional secured loans, with attractive returns, using a loan structure that can minimize its risk should the borrower default.
Legal Considerations for Crypto Lenders in Ce-Fi
Before offering a crypto loan, it is essential for the prospective lender to gain an understanding of the contractual mechanisms and remedies required both to take security over a particular crypto asset, and enforce their security interest in an event of default.
For example, a lender should take into account some (or all) of the following legal considerations:
- Regulatory Compliance. Ensure compliance with any regulatory regime that governs if and how it is able to make crypto loans.
- Taking Security. Determine how to take a first-ranking security interest over the crypto asset.
- Market Volatility. Consider how to safeguard its position from material volatility of the underlying crypto assets and the devise the appropriate mechanism and process to demand further collateral from the borrower if necessary.
- Crypto Asset Use. Understand rights the borrower will have with respect to the crypto assets serving as collateral during the term of the crypto loan. In some crypto lending arrangements, the lender may make money not only from charging loan fees and collecting interest on payments, but also from managing crypto deposits to earn yield revenues.
- Collateral Security. Develop methods to safeguard the security of the crypto asset during the term of the loan to prevent cyber theft, ensure appropriate key administration, and respond to certain blockchain related changes that may affect the collateral while in custody. Examples of blockchain related changes may include token swaps, roll-backs, or split / forks in a particular blockchain.
- Tax and other issues. Tax, transfer limits and other currency regulations may affect both how loan proceeds are transferred from the lender to the borrower, and the repayment of principal and interest from the borrower to the lender. The regulatory classification of the underlying crypto asset will inform the tax considerations and whether transfer limits may exist. Accordingly, the lender will need to consider the form of the crypto asset, be it a protocol token, application token, non-fungible token, etc., and determine its form of property, and how that will that impact loan considerations. A qualification as currency, tangible, or intangible property each carry different implications for structuring loan agreements.
- Repayment. How will the loan be repaid? For example, will it be repaid through cash installments or cryptocurrency?
- Security Enforcement. What contractual mechanisms and remedies are in place to enable it to enforce on its security in a timely manner?
If you are interested in participating in the crypto lending space, it is important that you consult legal counsel who have expertise in the secured lending and crypto space to ensure you are properly managing your risk.
For more information on crypto lending, please reach out to Ryan Middleton, Tracy Molino or Noah Walters at Dentons Canada LLP.