Crypto lending is now a "big thing." DeFi protocols, centralized services, stablecoin loans -- these are all very much in the news. All of this activity is unregulated in the sense that leverage is only limited by the risks involved parties are willing to take. Given the size and evident high risk tolerances of many participants in the space it's worth asking just how much leverage is floating around.
Market Setup
Let's start with two assumptions to simplify things:
- Loans are of stablecoin (STA) with crypto collateral (COL).
- At inception loans are X% overcollateralized with a single margin call when the value of the collateral drops to the balance of the loan.
These are broadly in line with the mid-2021 crypto markets. The most common case looks to be USD-something lent against BTC with an X of, say, 30%.
How Much Gross Lending Is There?
Within this structure it is perfectly plausible for a borrower to use their STA loan proceeds to buy more COL and then re-pledge. Given the lack of market-wide supervision and high risk tolerances it is reasonable to believe this kind of leveraged buying is normal. But how much can there be?
The math is straightforward.
The first loan is for 1. Let's assume that gets converted into COL without any fees. The second loan is then for
\begin{equation}\frac{1}{1+X}\end{equation}
And the third is for \begin{equation}\frac{1}{(1+X)^2}\end{equation}
If this process loops forever the total is \begin{equation}\sum_{i}{\frac{1}{(1+X)^i}} = \frac{1}{X}\end{equation}
Note this takes the initial loan's proceeds as 1 rather than the initial value of the collateral. It's cleaner that way and doesn't impact the high level conclusions. In fact it may more closely approximate the real world as discussed below.
Margin Calls and Liquidations
If all of this borrowing and lending happens at some price P (STA per COL) all the margin calls occur if P falls X%. This is obviously simplistic but it can still be instructive.
There is an obvious relationship among the degree of overcollateralization, the liquidation level and the size of the liquidation. Again assuming everything occurs at the same initial levels we have a liquidation at P/(1+X) for 1/X units.
Intuitively this makes sense: a lower X gives us a larger and closer stop-loss order. Lower X = higher leverage. This is a boring result.
Leveraged Buying
The giant stop-loss order is a sign a bunch of leveraged buying must have occured! This is also wholly unsurprising. Each incremental conversion of STA loan proceeds to COL is a crypto purchase. In total we also have leveraged buying of 1/X units of COL!
Stablecoin lending of this type, even with 100% backed stablecoins, can still generate a lot of upward pressure on prices given a sufficiently-well-functioning lending ecosystem.
This is a classic feature of traditional financial markets -- and a key reason for leverage supervision. Note that absolutely nothing dodgy is happening here. This may or may not represent more risk than the system can bear. But no individual actor is doing anything dishonest.
Also note there is no reason to believe sufficient backing exists for STA to liquidate COL into USD at it's price after the leveraged buying! The quantum of leveraged buying is entirely dependent on X. Presumably the price post-buying is therefore at least weakly dependent on X. But this has nothing to do with the quantity of STA outstanding. STA can be completely covered by USD reserves, and STA redemption itself be free of risk, but COL still cannot be liquidated into USD at the higher price given only STA's reserves.
Stablecoin Issuers
What if STA is also issued in this fashion, with overcollateralized COL as backing? Several major stablecoin issuers look to provide such loans. This depends a bit on what you think "approved investments" and similar phrases mean precisely but we are simplifying on purpose here.
If Y% of STA that's been issued is backed by COL then we only have USD backing to liquidate (1-Y)% of STA prior to any collateral sales. But selling COL for STA does not increase the balance of reserves! Raising reserves would require liquidating collateral in the COL-USD market.
Plugging In Numbers
Let's continue to use 30% for X. How much lending is there? Well one good place to start is the balance of stablecoin issuer non-USD-equivalent holdings. Let's take total stablecoin issuance at USD 100B and say a third is this type of lending. And all against BTC. This is a simplification. It's a basic model for stylized answers. Whatever.
This gives us total outstanding lending of USD 110B. At a price of 65k that is a stop-loss for 110B at 50k.
Also note that this assumes cash backing of 50B. There are not enough in the cash reserves to support this stop-loss order against USD even ignoring all other backed tokens.
The fragility of this system depends on X and Y. A lower X raises the risk. And a higher Y raises the risk. If Y is 0 the system still may not be able to convert all the tokens into hard currency at the prevailing price.
Extreme Scenarios
To illustrate plausible states of the world let's look some extremes, again starting from a 65k price.
First take X as 66% and Y as 10%. As a market-wide average this feels pretty conservative. In this case we have:
- 90B in USD reserves
- 10B in initial loans, 15B in total loans
- A stop-loss for 15B at 39k
Note that reserves are insufficient but barely. This likely doesn't scare anyone. Almost certainly it doesn't scare the median market participant.
At the other extreme take X as 10%, Y as 80%. Surely some lending is occuring at these kinds of levels but this is quite aggressive for the average. Anyway:
- 20B in USD reserves
- 80B in initial loans, 800B in total loans
- A stop-loss for 800B at 59k
That stop-loss requires liquidating 13.5 million coins -- this is obviously a total train wreck. You can find plasuible-but-too-aggressive sets of parameters where the total ecosystem market cap is insufficient to cover the stop-loss.
If X is 5% and Y is 90% then the balance of outstanding loans would be 1.8T. A stop-loss to raise 1.8T at 61.9k is impossible -- that would require selling 29 million coins.
Perhaps the real leverage limit in this market will prove to be the capped issuance. Any lender that sees stop-losses for 10%, or 20% or 50% of total coins outstanding knows they have a problem!
Spoiler alert: the inability to inject temporary liquidity is a known problem with fixed exchange rate regimes.
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