Already a multi-billion dollar industry supported by a trillion dollar asset class, Bitcoin-backed loans and other secured lending arrangements involving crypto assets continue to grow in variety, scope, and access, and offer borrowers access to capital that, as with traditional lending arrangements, can be used to finance businesses, homes, cars, and other personal property. For example, Toronto-based lending platform, Ledn, closed 2021 by completing its Series B financing and has estimated that it will originate over CA$100 million in Bitcoin-backed mortgages in the first quarter of 2022.
This insight discusses secured crypto lending, its benefits, and key considerations for borrowers and lenders.
What is secured crypto lending?
Secured crypto lending refers to arrangements where a borrower pledges crypto assets as security for a loan, often in the form of fiat currency. Secured crypto lending can relate to real estate (mortgages), auto loans, personal property, or other commercial or personal purposes. In most secured crypto lending arrangements, the repayment of the loan will be in fiat, as opposed to digital currency, but either is possible and offered by various crypto lenders. If a borrower fails to repay a loan or breaches a material provision of the loan, the lender will typically have the contractual and operational ability to make use of the pledged crypto assets to satisfy amounts owing to it under the loan. Terms of the loan, including repayment schedules, rates of interest, currency of repayment, and restrictions applicable to the borrower, will be set out in a loan agreement, which will be supported by general security agreements and pledges of the crypto assets securing the loans.
The crypto lending market, like the blockchain and digital asset industry at large, continues to rapidly evolve but is represented by a diverse group of lenders and borrowers. There are many lenders – online and otherwise – that allow borrowers to obtain loans against cryptocurrencies, including some platforms that also facilitate the purchase or trading of crypto assets – see our previous article for securities law considerations applicable to crypto asset trading platforms. The rates of interest and other terms offered by lenders can vary widely across platforms and depends on a variety of factors, including the type of cryptocurrency being used as collateral for the loan. In addition to interest rates, borrowers will want to give consideration to the reliability of the lender and the platform to ensure that collateral will be returned upon repayment of the loan. The loan may also take the form of a repo arrangement whereby the borrower sells the crypto assets to the lender with an agreement to repurchase the collateral at a specified time and price.
Benefits of (secured) crypto lending
One of the primary drivers behind the growth of the crypto lending market has been the desire of borrowers to obtain liquidity by leveraging value that has accrued and is stored in digital assets without selling those digital assets. Many borrowers will pledge digital assets that, if sold, would be subject to capital gains; obtaining a (secured) crypto loan enables the borrower to obtain liquidity without incurring tax liability. A similar rationale applies to borrowers who wish to obtain liquidity but also believe the value of the pledged crypto assets will increase over time. Some borrowers may also be eligible to deduct interest payments on crypto loans paid in fiat currency, providing another avenue for such borrowers to benefit from value stored in digital assets. Another factor in the growth of the crypto lending market is that certain types of secured crypto loans are often not subject to credit checks, making them a potential source of capital for a broad range of borrowers. Settlement of secured crypto loans depends on the nature of the security taken by the lender but can be accomplished quickly, a key advantage for both borrowers and lenders over traditional secured lending arrangements in terms of speed, transaction costs, and efficiency.
As with traditional secured lending arrangements, lenders benefit from the comfort provided by taking security over digital assets, many of which can be liquidated for fiat currency with minimal cost and administrative expense if the crypto assets securing the loan have an active and liquid market.
Risks and key considerations
An important consideration for borrowers and lenders in relation to secured crypto loans will be the process of granting or taking security over digital assets and determining if the processes applicable to securing other “intangible” assets applies to crypto assets and, if so, under what circumstances. Lenders and borrowers should consult legal advisors in the preparation of the registrations against crypto or other intangible assets to avoid errors and minimize the risk.
As with traditional secured lending arrangements, crypto lending arrangements may (i) involve due diligence by the lender relating to the borrower and its ability to repay the loan, and (ii) impose restrictions on the borrower’s ability to use the collateral during the term of the loan. Often, borrowers will not be able to sell or transfer collateral and lenders will have the benefit of mechanisms that will provide them with control over the digital assets (or the accounts in which the digital assets are held) in the event of a default under the loan. These arrangements often resemble traditional deposit account control agreements or blocked account agreements.
Another key consideration for borrowers and lenders in secured lending arrangements is the concept of the loan to value (LTV) ratio, which is the ratio by which the value of the collateral to the value of the loan. If the value of the collateral falls below a prescribed threshold, the borrower will typically be given a period of time to pledge additional collateral to secure the loan. If the borrower fails to pledge the additional collateral within the required timeframe, the borrower may be subject to a margin call and the lender may be able to enforce its security. Given the volatility in the price of many crypto assets, both borrowers and lenders should be mindful of, and carefully negotiate, the provisions of the loan arrangement relating to the LTV ratio.
Lenders and borrowers should also consider if the crypto lending arrangements give rise to securities law issues, including the transfer of securities, either because the enforcement of security involves the transfer of crypto assets that are securities or because the crypto loan itself is a security. As noted in our previous article, which set out considerations for Canadian crypto lending platforms, certain crypto lending offerings have drawn regulatory scrutiny and have been the subject of enforcement actions in the United States2 and Canada.
As we begin 2022, Bitcoin-backed lending and other secured lending arrangements involving crypto assets continue to be an ever-increasing source of liquidity for borrowers and crypto investors that wish to remain invested in crypto markets while accessing liquidity otherwise stored in digital assets that may also be subject to significant tax liability. Similarly, lenders have originated loans supported by digital collateral, recognizing the potential efficiencies and simplicity of liquidating digital assets for fiat currency. These loans and arrangements raise a number of legal issues, including the method and manner in which security will be perfected, the covenants and other restrictions applicable to borrowers, and the mechanisms for protecting digital assets and taking possession over them in the event of a default. Crypto lending platforms operating in Canada should be mindful of the securities law considerations applicable to the lending of crypto assets and the regulations applicable to the platforms that enable such activity, especially in light of increased regulatory scrutiny of crypto lending activities in the United States and around the world.