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Responsible Lending Supports Growth

Published, 21 September, 2022

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Blog Image for the Response Lending Support Growth Post
Over the past few months, many of our clients have asked BlockFi to discuss and compare traditional and crypto industry practices involving collateralized and uncollateralized lending. We believe that’s an important question, and a great opportunity to offer insights on how lenders typically price and manage the embedded risks associated with both collateralized and uncollateralized lending.
Many of the biggest lending losses reported recently in both crypto and traditional markets involved collateralized loans. For example in the Summer of 2022, many of the widely reported CeFi industry losses were related to either fully or partially collateralized loans to Three Arrows Capital (3AC). In DeFi, the Terra stablecoin UST was collateralized primarily by Luna tokens via a stabilization algorithm, which infamously spiraled close to zero value, severely impacting depositors into UST.  And in TradFi just last year, some of the largest and most sophisticated Wall Street banks lost a combined $10 billion dollars lending to a single client, Archegos Capital, in collateralized lending activity in their prime brokerage units. By contrast, to date BlockFi has not had a loan default which was underwritten to a fully unsecured basis.
These examples illustrate that it is not as simple as collateralized lending is “safe” and uncollateralized lending is “unsafe”.  Both types of lending require specialized expertise and risk management capabilities, and both benefit the crypto ecosystem. They both require significant resources to perform client onboarding, scrutinize borrower financials, negotiate loan terms,  analyze available collateral,  and monitor borrower performance over the life of the loan. Lending also requires seasoned risk managers, credit underwriters, and compliance and legal professionals who understand credit risk in different market conditions and have the ability to work out problematic loans if the need arises.
In this paper, we describe the key capabilities required to effectively offer collateralized and uncollateralized credit and provide details on the significant investment we have made at BlockFi in these capabilities.  
Collateralized Lending
The majority of institutional loans deployed at BlockFi are currently collateralized, as we shared in our Q2 2022 Transparency Report. While collateral can be a highly effective risk mitigant when structured properly, collateral by itself is insufficient and needs to be complemented by a comprehensive risk framework, including some of the following features: 
  • Contractual rights to act quickly (typically 24-48 hours)
  • Limits on the gross (pre-collateral) loan size
  • Limits on the type and quantity of acceptable collateral
  • Sophisticated modeling to determine the amount of collateral needed for each specific lending situation 
  • Risk systems complemented by an experienced trading and risk management team monitoring the portfolio 24/7
  • Collateral management and wallet operations for digital assets which are subject to strict compliance and cyber-security reviews 
  • Trading expertise and knowledge of market dynamics for each collateral type
  • Access to multiple exchanges and OTC desks to liquidate collateral quickly, with minimal slippage
  • Borrower underwriting capabilities, as a fallback for potential collateral shortfalls in periods of extreme stress
  • Strong risk culture, starting from the top, that allows an organization to act quickly and in the best interest of our clients
At BlockFi, we have invested heavily in expertise and resources required to meet these needs. In addition, we have developed a number of differentiated collateralized product features that borrowers seek, such as stable interest rates, term loans, margin cure periods, and other institutional-grade offerings. Strong collateralized lending practices enabled us to proactively identify issues, and limit losses during the recent market disruption, including limiting the damage from the 3AC default and consequent knock-on impacts.  
Uncollateralized Lending
While the majority of the BlockFi loan book is currently collateralized, we also generate yield from uncollateralized lending, similar to traditional banking institutions. When evaluating whether a client is eligible for uncollateralized lending, they are subject to a rigorous credit underwriting process, as we described in our article: An In-Depth Look at BlockFi’s Risk Management
In traditional banking, uncollateralized lending ranges from the very risky, such as consumer credit cards, to the significantly less risky, such as loans to large investment grade corporations (for example, a loan to Apple). Lending on an unsecured basis typically commands a higher interest rate versus collateralized lending, which needs to be weighed against the additional risk. Lenders typically look for strong unsecured borrowers that can offer attractive risk/reward opportunities and enable the lenders to generate additional yield to the benefit of investors and clients.  
At BlockFi, fully uncollateralized lending is limited to our largest and most established Tier 1 clients that have a significant capital base, verifiable financial position and a willingness to be transparent and engaged with us to facilitate ongoing credit monitoring. These Tier 1 clients, which operate in both traditional markets and crypto markets, typically represent an attractive risk/reward profile because despite their strong balance sheets, TradFi banking institutions are not currently set up to support these clients across digital assets borrowing and lending activities.
The profile of clients who are able to obtain uncollateralized credit from BlockFi are often able to deploy that capital productively and efficiently into the ecosystem. For example, market makers use the funds they have borrowed to provide liquidity on multiple global crypto exchanges simultaneously, thereby lowering trading spreads and improving price discovery and execution for end-users. Crypto companies often use borrowing facilities to support and grow their businesses, which in turn stimulates growth of the ecosystem.
Just as collateralized lending requires a robust risk management framework, so too does uncollateralized lending.  A core tenant is: “don’t put all your eggs in one basket”. In a credit risk framework, this principle is implemented through “concentration limits”, which is critical for all lending firms. Our concentration limit framework is directly informed by the size of our lendable assets, and the amount of loss-absorbing risk capital available to us.   
We’ve historically limited unsecured loans to any single borrower client to well-below 5% of our deployable assets. We also maintain credit reserves and additional risk capital in our entities that make loans to help protect against a range of severe market scenarios, including protecting our ability to meet client withdrawals in the event of losses related to potential simultaneous defaults of multiple unsecured borrowers.
To offer unsecured credit, we first negotiate a very detailed legally enforceable contract with all of our borrowers. These contracts establish BlockFi as a senior lender with full recourse to the borrower’s assets, and include financial and non-financial covenants and remedies. These covenants allow BlockFi to monitor the credit quality of the borrowers on an ongoing basis and take action in case of certain events or conditions (e.g. material adverse developments) of any number of conditions that constitute an event of default (e.g. a decline in Net Asset Value). These types of legal contracts have a long established history in traditional finance markets. 
All borrowers then undergo an extensive due diligence and underwriting analysis which includes a review of their operation and financial statements, with focus on leverage and liquidity. The credit evaluation considers many factors, where relevant including:
  • KYC/AML:  All borrowers undergo Know Your Customer and Anti Money Laundering checks required by US regulation. No exceptions.
  • Business model: Business models in the crypto space vary, and each type has its own idiosyncrasies that we take into account. For example, the risk associated with a market neutral market maker is different from a statistical arbitrage fund, which is different from a long/short crypto hedge fund.
  • Financial strength and health: The financial position of a company will ultimately determine its ability to pay. We analyze the assets and liabilities of our borrowers, and lend to companies we determine to have a strong financial capacity to repay loans.
  • Organizational structure: Most companies have multiple legal entities in their organizational structure. It’s important to review the organizational position of the entity which is borrowing, including relationship to other entities in the organization, and proximity to the company’s overall asset base. 
  • Industry dynamics: The counterparty’s position within the industry as well as supply and demand dynamics impact a counterparty’s ability to pay; we also adjust our overall risk appetite during risk-off environments.
  • Client reputation: The counterparty's reputation and those of its senior management can be a valuable credit indicator. The analysis may include review of historical reputation of market participants and associated business practices.
  • Track record: The historical performance of the potential borrower, but also the track records of the trading teams and senior management at their prior firms.
  • Quality and frequency of financial disclosures: Audited and/or third party verified financial disclosures are an important indicator of maturity and credit health of the borrowers, and the level of detail and sophistication of various financial disclosures which are provided requires underwriters to have extensive backgrounds in financial statement analysis.
  • General transparency: Frequent engagement with borrowers may include regular credit checks and ongoing dialogue throughout the year, to monitor loan covenants and other performance measures.  
For counterparties engaged in trading activities, we also assess their risk management framework to ensure it is up to par with BlockFi standards. Cases where certain information is not available or only partially available, ultimately impacts our credit decision and the amount of credit which may be extended to these borrowers.

Conclusion 

We are encouraged by the healthy industry debate regarding lending practices in CeFi and DeFi as this dialogue helps to identify and improve risk management practices across the  digital asset industry. We believe both collateralized and uncollateralized lending offer a valuable product for market participants, are important for the growth of the ecosystem, and ultimately benefit all users of the digital assets. In this paper, we highlighted key capabilities needed to offer collateralized and uncollateralized credit and have noted the significant investment in these capabilities that we at BlockFi have made. 
Looking to the future, there are a number of additional developments in the crypto markets that will enable even stronger and more prudent risk management practices. We are encouraged to see initiatives focused on developing tools and pooling data to assess and mitigate credit risk, including i) tools that collect and analyze off chain and on-chain data to enable credit evaluation and scoring, ii) KYC/AML passports that allow the growth of compliant on-chain venues dedicated to permissioned entities, iii) self-organized industry bodies being created to establish and raise lending standards, iv) prime brokerage solutions for institutional crypto participants, and v) introduction of real-asset off-chain collateral, which will enable an expanding population of borrowers, such as non-digitally native small businesses. These recent trends, and similar initiatives, help to bring risk management capabilities to the digital asset industry, which traditional lenders employ, to support a diverse set of customized lending products and ultimately fuel the growth of economic activity. In our view, “This is the way”.
Disclaimer: Nothing contained in this announcement should be construed as a solicitation of an offer to buy or offer, or recommendation, to acquire or dispose of any security, commodity, investment or to engage in any other transaction.  The information provided in this announcement is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. This announcement is not directed to any person in any jurisdiction where the publication or availability of the announcement is prohibited, by reason of that person’s nationality, residence or otherwise. Neither BlockFi nor any of its affiliates or representatives provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions. Digital currency is not legal tender, is not backed by the government, and crypto interest accounts are not subject to FDIC or SIPC protections. BlockFi International Ltd. is licensed to conduct digital asset business by the Bermuda Monetary Authority.
This communication contains “forward-looking statements”, which involve risks and uncertainties. You should not place undue reliance on forward-looking statements because they are subject factors which are difficult to predict. These forward-looking statements are generally identified by the use of “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “target,” “will,” “would” and similar expressions. We do not undertake to update any forward-looking statement as a result of new information or future events or developments.

Last updated on September 21st, 2022

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Digital currency is not legal tender, is not backed by the government, and crypto accounts held with BlockFi are not subject to FDIC or SIPC protections. Digital currency values are not static and fluctuate due to market changes. Not all products and services are available in all geographic areas and are subject to applicable terms and conditions. Eligibility for particular products and services is subject to final determination by BlockFi. Rates for BlockFi products are subject to change.
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This icon serves as a link to download the eSSENTIAL Accessibility's free assistive technology app for individuals with physical disabilities.
Digital currency is not legal tender, is not backed by the government, and crypto accounts held with BlockFi are not subject to FDIC or SIPC protections. Digital currency values are not static and fluctuate due to market changes. Not all products and services are available in all geographic areas and are subject to applicable terms and conditions. Eligibility for particular products and services is subject to final determination by BlockFi. Rates for BlockFi products are subject to change.
BlockFi Rewards Credit Card: For more information, please see BlockFi’s Terms of Service. BlockFi is not a Bank. Cards are issued by Evolve Bank & Trust, Member FDIC, pursuant to a license from Visa® USA Inc. Rewards are not offered by Evolve Bank & Trust and are instead offered and managed by BlockFi.
BlockFi International Ltd. holds a Class F digital assets business license under the Digital Assets Business Act, 2018 (as amended) and is licensed by the Bermuda Monetary Authority to conduct the following digital assets business activities: (i) issuing, selling or redeeming virtual coins, tokens or any other form of digital assets (ii) operating as a digital asset exchange (iii) providing custodial wallet services (iv) operating as a digital asset derivative exchange provider and (v) operating as a digital assets services vendor.
See blockfi.com/terms for more information.
2022 © All Rights Reserved.