The collapse of several crypto firms in the last year because of the plummeting digital asset prices has posed a challenge to the operations of crypto banks. The lack of a clear and comprehensive crypto regulatory framework has seen crypto lenders operate differently from traditional banks, which has posed a risk to investors.
Crypto banks are most in debt to themselves
A Bloomberg report pointed out the differences between traditional and crypto banking. In the traditional banking sector, frameworks such as the lender of last resort and deposit insurance make the possibility of a bank run less likely. However, the same rules do not apply to crypto lending firms and crypto banks.
While the news of bank runs in the crypto industry has become popular over the past year, it is not the first cycle where this is happening. In 2018, Bitfinex, a cryptocurrency exchange, lost a significant amount of customer funds, which triggered an increase in withdrawal volumes.
To cover the gap, Bitfinex took out a $625 million loan from USDT issuer Tether to meet withdrawals. The money allowed Bitfinex to continue operating and return to profitability. Tether received a $625M IOU from Bitfinex for the money.
However, the deal landed Tether in trouble with New York regulators as this type of transaction is not considered 100% legitimate in accounting. Tether is supposed to be 100% backed by assets, but the $625M loan now meant that USDT was backed partly by assets and partly by an IOU from a sister company.
While the situation between Tether and Bitfinex could be narrowed down to the companies operating in an unregulated space, the events that happened last year showed that some crypto lending platforms were engaging in risky investments, which made them go under.
Some platforms used customer deposits to make loans, and when these loans were not repaid, it triggered panic, and the platforms could not meet the high withdrawal volumes. Such is the situation that happened with Celsius, Voyager, and BlockFi. However, last summer, there was a kind of lender of last resort in the crypto market, Alameda Research.
FTX and its sister company Alameda promised bailouts to crypto firms struggling to sustain operations to prevent them from going under. However, the bankruptcy of FTX in November and the commingling of customer funds between FTX and Alameda did not see any of these bailouts work.
Genesis could be the next crypto lender to fall
Genesis crypto lending unit is currently in a similar situation. Gemini encouraged retail depositors to deposit money to Gemini Earn to earn interest. Gemini lent out the money to Genesis, which in turn lent it to large hedge funds. In November, Genesis halted withdrawals, which saw Gemini Earn product users unable to recover their funds.
While Genesis says that its liquidity crunch was triggered by exposure to FTX, it is now emerging that the lender was in a tight financial position after the fall of three Arrows Capital in June last year. At the time, Digital Currency Group, Genesis’ parent company, wrote a $1.1 billion IOU to Genesis in July that boosted confidence and slowed down withdrawals. However, the exposure to FTX dented confidence, and another IOU from DCG could not have worked.
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