The recent SEC settlement against cryptocurrency firm BlockFi may set precedent for broader regulatory crackdown against the undisclosed risks of crypto lending, which should result in increased conformance to regulation by centralised digital asset firms. This, along with other regulatory developments and more clearly defined restrictions for centralised and decentralised finance (DeFi) firms, would be credit positive for the sector, Fitch Ratings says.
Under the settlement with the SEC and state regulators, BlockFi will pay $100 million in penalties for offering unregistered BlockFi interest accounts (BIAs) that offer high annual percentage rate (APRs) to customers to lend out digital tokens. BIAs must now be classified and registered as securities under applicable security laws, as BlockFi does not qualify for an exemption from SEC registration. BlockFi agreed to cease offering or selling BIAs in the U.S. until it registers its crypto lending products.
The crypto ecosystem offers income and yield products, not unlike savings accounts at commercial banks that pay APRs on customer deposits but at much higher rates, some nearing 20%. However, the liquidity lock-up and the risks faced are significantly different. Crypto interest accounts are not FDIC-insured and have increased risk of loss from cybercrime or crypto lenders being hacked. BlockFi’s crypto deposits, which are around $10 billion, were lent out to institutional counterparties, with only 17% of loans being over-collateralised despite representations that such loans were “typically” over-collateralised.
Increased disclosure and regulatory requirements and the classification of digital assets as securities could accelerate the growth of crypto by attracting more investors. However, this will also translate into higher costs and compliance hurdles for crypto firms and lower yields, which could make it less attractive to retail investors seeking higher APRs.
The settlement could also accelerate fintech compliance with securities legislation. Crypto lending firms have criticised lack of clear regulatory guidelines and have disputed the securities classification of depository offerings. Firms lend out deposits to institutional investors at higher rates or borrow against crypto to execute their trades or to take advantage of price discrepancies in other financial instruments. Regulators have scrutinized crypto lending firms’ use of deposits to fund other business activities, however no uniform rules currently exist that indicate how the deposits can be used.
Yield farming through DeFi involves liquidity providers encumbering tokens into a smart contract-based liquidity pools, with assets lend to institutional borrowers, earning a fee for the crypto asset provider. This can expose liquidity providers to “impermanent losses” arising from the price of tokens changing when they withdraw from the liquidity pool compared to when the tokens were first deposited in the pool. In addition, there are software risks, and ultimately, no public backstop such as FDIC insurance.
Following the BlockFI settlement, crypto platform Nexo indicated that it will also register its depository offerings and has amended the terms for U.S. customers who had received high APRs on crypto deposits. Nexo’s current U.S. customers will be able to continue earning high rates on existing digital-asset balances but not on new deposits. New U.S. clients will not be offered the product; however, non-U.S. customers will remain unaffected.
Coinbase Global had planned to offer similar accounts but dropped that proposal after increased scrutiny by the SEC, which had also been reviewing product offerings and registration of Gemini Trust, Voyager Digital and Celsius, which has more than $20 billion worth of deposits.
Regulatory action against centralised digital asset companies offering crypto lending accounts would be a logical target, as their corporate structure affords regulators the ability to enforce rules and to collect fines. Conversely, enforcement actions against DeFi protocols and applications will be much more difficult.