As American borrowers face an upcoming credit crunch, with average debt levels higher than 2008, many crypto investors are seeking to cash out their digital currency holdings in exchange for a dollar-denominated loan. But as crypto loans grow, the loosely regulated industry is also drawing increasing government scrutiny.

Despite being outside mainstream financial markets, these new lending products are catching a lot of investor attention. 

In 2019, crypto loans grew 700% from the year before, from $1 billion in loans originated globally to $8 billion, according to Credmark, a crypto credit research and data firm based in Singapore. Over the same time, total collateral deposited grew from $1.5 billion to $13.5 billion, roughly equivalent to the nominal GDP of Mongolia

See related article: Are US regulators finally warming to crypto and digital assets?

Even the coronavirus has not been able to keep the crypto loan industry down. While cryptocurrencies and exchanges convulsed with the rest of the Covid-ravaged global economy earlier this year, the crypto loan industry kept growing. According to Credmark, active crypto debt in the first three months this year grew by 44%, while assets under management grew by 75%.

Private crypto credit firms “continue to demonstrate impressive stability in an industry built upon inherently volatile assets,” Credmark concluded, in its 2020 Q1 report. Private firms are especially optimistic for 2020, the report added, “maintaining a bullish outlook for the rest of the year.”  

Crypto loans have grown in popularity along with the rise of decentralized finance (DeFi) as they offer several advantages to consumers. They allow the leverage of dollar-denominated loans with the arbitrage of future crypto gains. For some borrowers, they can provide reduced tax penalties. They can also potentially earn more money for consumers with their higher return on investment (ROI). 

Compared to traditional finance, crypto loans have much more relaxed barriers to entry for lenders and especially borrowers. Even subprime borrowers with poor credit can qualify for crypto loan products so long as they put up enough collateral, which is typically 150% of the loan amount. 

Most crypto loans, especially those sponsored by European crypto loan companies, offer loans that average around US$20,000, with some HODLrs taking out loans in the hundreds of thousands, according to BlockFi and YouHODLer. American companies tend to deal with smaller loan amounts, usually averaging around $10,000. 

“We’re really where lending is when it comes to small businesses,” said Saher Zoabi, operations director of German crypto loan provider Bitbond. 

Unlike many crypto loan services, which offer loans in-house, Bitbond provides peer-to-peer lending with corporate support, Zoabi said. “Bitbond connected global lenders to those unserved by banks, whether they can’t get to one or are high risk borrowers, especially in terms of credit.”

Crypto loans are booming, industry insiders say, because of growing interest in alternative currencies as well as greater crypto adoption.

Abra crypto
The SEC and CFTC have cracked down on Abra, a DeFi platform. Image: Shutterstock, Decrypt

“More people are getting into the market — and [the market is] active enough to maintain short positions,” Ilya Volkov, founder and CEO of YouHODLR, told Forkast.News. He also credits bitcoin halving — which some investors believed would cause a rise in BTC value. “The recent discussion brought new people along for the market.”

Crypto loan borrowers are typically long-time crypto users who are seeking liquidity in USD, having accumulated tens of thousands worth of cryptocurrency through mining or investment. Borrower creditworthiness requirements vary between companies, with most operating similarly to a pawn shop — using only the transferred crypto collateral to secure a loan. 

But regulatory storm clouds may be gathering over this nascent industry. The IRS is placing cryptocurrency users, including lenders and borrowers, under increasing scrutiny, tax experts say. The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) — are also sending a public message to the industry by targeting Abra, the crypto app, in a coordinated manner.

The DeFi platform, which allows users to trade tokenized equities, also offers peer-to-peer lending as a potential use case. The SEC charged Abra with offering and selling security-based swaps without registration, and CFTC accused the company of entering into illegal off-exchange swaps in digital assets and foreign currency. On the same day last month, the regulators announced that the DeFi company settled the charges with each agency by agreeing to cease-and-desist orders and pay $150,000 in penalties. 

Regulators’ ire over users being able to purchase equities with “synthetic exposure to price movements of stocks and exchange-traded fund (ETF) shares” through a blockchain service may offer a clue as to where government scrutiny could go next, considering the international markets and tax issues involved with crypto loans.

Are crypto loans “helicopter money”?

Other than possible tax savings (or avoidance), what are borrowers doing with their crypto loans?

While the phrase “free money” has been used by economists to describe the purchasing price of capital at near zero interest rates, crypto loans may tell a different story. 

According to David Olsson, Global Managing Partner of Europe and APAC at Consensys-backed BlockFi, crypto loan borrowers have been using their borrowed fiat currency to invest in other asset classes. BlockFi has more than 90 institutional clients, including international financiers and private hedge funds, and has raised more than $100 million in capital funding. 

“With rates where they are, we may see a turn in the cycle — where right now is an uncertain time to invest,” Olsson told Forkast.News. “However, people may want to take out loans through BTC to invest in other asset classes. That’s the most probable use case.” 

While that may be the case for many BlockFi users, YouHODLR CEO Volkov says the Cyprus-based firm’s user base tend to use their loans to finance mining expenses or engage in arbitrage trading against the market. 

“We have two main borrower types. The first is a traditional HODLR — a crypto enthusiast. They are open minded and have decided to invest in [cryptocurrency], but they need cash for expenses,” Volkov said. “The second type is a crypto trader who uses loan collateral to buy more crypto, someone of an active investor profile.”

The inherent risk in doing so, in taking out a crypto loan is, of course, the volatility of cryptocurrency prices. In case of default, if the borrower doesn’t pay back the loan, the lender gets to keep — or would be stuck with the cryptocurrency collateral.

But with no unified exchange, no defined regulatory framework and no physical asset base, how can submitted collateral match to a USD loan if a cryptocurrency’s price were to drop dramatically? The risks may be magnified in the current coronavirus recession. 

According to Olsson, addressing this concern was a strong priority for the BlockFi ecosystem, especially in light of emerging cryptocurrencies and the recent BTC halving. 

“We have continuous risk systems [for distributed loans] running 24/7 to react as quickly as possible,” Olsson said. 

money, loans, cash
The trend of borrowing USD against crypto holdings is growing. Photo: Alexander Mils

Another factor driving crypto loans’ increasing popularity may be the interest rates, which are much higher than those on traditional loans. 

Compared to the estimated up to 8 to 9% ROI on a crypto loan, you would be lucky to have half that on a traditional investment account, which also carries risks. With a 2% ROI on a Treasury index and the uncertain outlook for the stock market in the pandemic economy, the case for crypto loans may be highly persuasive to some lenders. Corporations also promote themselves as groups that merely link lenders to borrowers — largely avoiding the question of taxes or other regulations. 

Faced with the threat of near-zero interest rates in interbank lending, YouHODLR’s Volkov believes that crypto loan companies should integrate with traditional Wall Street financiers. If many are seeking a way to earn interest on financial capital, why not provide one through crypto — and give them an incentive to further integrate into the blockchain ecosystem?

“I see good synergy between crypto and the traditional banking industry,” Volkov said. “On one hand, we have banks who are really tired from zero or near-zero interest rates. They face significant losses in their revenues, but they have really good financing infrastructure. On the other hand, we have crypto companies with high interest rates, but little infrastructure.”

Others disagree. After all, cryptocurrency is not embraced in every financial circle. While crypto is gaining a solid foothold in fintech, it’s still not adopted at a marketable rate for some consumer-focused financial institutions. Widespread acceptance may still be a long way away. 

“The opportunity for BlockFi is still in the asset class that needs widespread acceptance,” Olsson said. “I don’t see major banks coming in to provide these loans.”

Great Crypto Recession

While the crypto loan market continues to grow and shows no sign of leveling off, the next frontier, industry insiders say, may be the securitization of crypto loans. 

SALT Lending, a Denver-based crypto loan company, announced plans to securitize crypto loans in 2018, packaging crypto loans to sell to institutional investors. Through a proprietary interface for loans, the company has expanded its user base and now accepts collateral in a variety of forms, including Dogecoin and PAX Gold. Recently, the company partnered with Cadence, a leader in digital asset securitization.

SALT Lending’s planned offering is now outside the public sphere — raising questions whether the offering is ongoing or even cancelled. And with that comes the nightmares of how mortgage-backed securities caused the Great Recession. 

SALT Lending did not respond to inquiries regarding securitization of crypto loans at the time of writing.

What happens when these loans go into default? If crypto prices crash, will DeFi lenders, too — like banks did during the 2008 housing bust?

In these pandemic times as bitcoin and other alt currencies are riding high, crypto loan companies don’t seem much concerned.

BlockFi, for example, says it has a zero percent loss rate.

“BlockFi has a proprietary risk model that is equipped to handle market volatility, which has enabled them to maintain a strong balance sheet and zero loss record for [lending and borrowing clients],” a BlockFi media relations representative told Forkast.News. 

Is the IRS on the move

A further benefit to crypto loans is reduced tax burdens. But that could also be changing soon.

paying taxes
The IRS is cracking down on underreporting of crypto taxes. Photo: meddygarnet, CCBY

David Kemmerer, Co-Founder and CEO of CryptoTrader.Tax, believes there has been increased demand for crypto loans due to the IRS’s crackdown on those underreporting their crypto taxes. People are trying to hop on the crypto loan train while they still can. 

“People use crypto loans for a number of reasons — one of them is the tax advantage,” Kemmerer said. “If I borrow USD against my crypto holding, I don’t have to pay capital gains taxes. These loans could give them some liquidity, and that’s very sustainable.”

But the Internal Revenue Service is now also showing signs it is not pleased with the crypto industry.

“In 2019, we saw the IRS send out over 10,000 warning and action letters to those who they suspected of underreporting with the Coinbase subpoena,” Kemmerer said. “That’s either from capital gains from long-time investors or those who didn’t report the interest from another crypto account.” 

Even as CryptoTrader.Tax’s user base has increased, Kemmerer estimates that more than half of crypto users out there are still not reporting their capital gains when it comes to crypto. That’s concerning to the IRS, not only as an issue of underreporting, but of understanding currency flows of USD outside the United States. 

“They’re really focused on making sure that [crypto] doesn’t just become a safe haven for tax evasion,” Kemmerer said. “As more and more pressure [against crypto] gets applied by governments around the world, tax tools like ours become more in-demand.” 

Sharon Yip, the founder of Crypto Tax Advisors, a Washington D.C.-based crypto accounting firm, noted that cracking down on crypto tax delinquency, especially in those not reporting interest on crypto loans, is becoming a top priority for the IRS.

“Although I’m limited in what I can say, the IRS has gone after clients with full force regarding people who have underreported on their taxes,” said Yip, in an interview with Forkast.News. “They’ve filed subpoenas, sent out demands and, yeah, made arrests.”

Atomic Loans, a Toronto-based crypto loan firm promising a way for borrowers to control their crypto assets while receiving an instant loan, recently received $2.5 million in funding from Initialized Capital and ConsenSys. Their loan management system is designed to give users access to a loan through their personal Atomic account. 

“Atomic Loans seems to be doing it in a legal way -— but that sort of tax loophole can’t last forever,” Yip said. “Eventually, you have to pay capital gains taxes on whatever happens. If you take out a loan in USD against your crypto, that may be beneficial in getting instant liquidity, but eventually, you’re going to buy/sell crypto — and that’s an additional taxable event.”

Others don’t see a need for the increasing regulation of cryptocurrency, contending that crypto-based financial products are not only more transparent but also more publicly accessible than traditional forms of investment. 

“No one can have inside information on Bitcoin, Ethereum, Litecoin or Ripple,” said Olsson, of BlockFi. “It’s a store of value. It’s a method of monetary transfer and payment. It doesn’t give you a right to own anything else.”

While that may be the case, Yip’s recent experiences has led her to the conclusion that the IRS isn’t messing around when it comes to crypto tax underreporting. 

“Due to the growth in crypto loan demand, they’re really concerned about how the industry is growing from now,” Yip said. “That’s one of their top priorities in the coming months. I wouldn’t be surprised if the [federal government] moves forward with cracking down more after this pandemic subsides.”