We are all familiar with the theoretical benefits of peer-to-peer lending: It can be good for borrowers if they get access to capital that they wouldn’t have otherwise received from banks. And it can be good for lenders who have access to a source of return for their capital that is otherwise restricted to banks or other professional financial services. However, we all know what can go wrong – and a lot has recently gone wrong in traditional P2P lending. Mainly, credit default rates have been much higher than in the past, driven in part by the corona crisis, and that has left many investors with significant losses in capital and a bleak outlook on future returns.
Interestingly, there has been an alternative form of P2P lending that hasn’t suffered at all during the corona pandemic. In fact, it has been growing and generating returns steadily throughout the past 8-9 years. We are talking about ‘margin funding’ – a mechanism that is used to fund traders on crypto exchanges. Even though that sounds risky, its advantages in risk management are exactly what makes it interesting.
How does margin funding work? Margin funding in itself is an age-old concept and refers to the provision of capital to traders who want to leverage their positions, i.e. add borrowed capital to their equity in a trading position in order to amplify the return on equity in that position. Traditionally, this capital has been provided by middle men such as banks or brokers. Some crypto exchanges – with little capital when they started – innovated in the field and have started to offer peer-to-peer markets for margin funding. This means that market participants can not only trade on those exchanges but they can also lend each other money. One of the leading providers of this service is Lendary.
The interesting aspects of this alternative form of peer-to-peer lending are to be found both on the risk and the return side.
In terms of risks, there are two main features that make margin funding much less risky than traditional P2P lending. First, the borrowed capital can never leave the trading platform and can only be used for trading on that platform. This way, borrowers can not just ‘take the money and run’. Secondly, and even more important, there is an automated liquidation mechanism that makes sure that trading positions would be liquidated before any capital from the lender is lost in the process. This means that the trader may very well lose money on an individual position but since each position is always composed of an equity portion and a debt portion, the position would just be liquidated as soon as a certain loss threshold in the equity portion is crossed. By executing this system, exchanges put lenders in a highly favorable position since there capital is not touched by any losses. Also, since crypto trading runs 24/7, there is no overnight risk as opposed to traditional asset markets. As a result, Lendary didn’t have a single credit default in the 2 years of its existence and their partnering crypto exchange, Bitfinex, claims the same for the past 7 years.
In terms of return, Lendary is an equally interesting platform since returns have usually been between 10-15% p.a.. This is due to the fact that traders on crypto exchanges have a fairly high willingness to pay interest rates for short term trading loans. Their trading approach is mostly speculative so they don’t mind fees of 3-10 basis points per day given that they expect Bitcoin and co. to move multiple percentage points each day. Also, the capital that is provided on those crypto exchanges is still rather ‘unprofessional’, so it’s other retail investors but no real big institutional players who could drive down interest rates.
Lendary itself is one of the leading software service in the space. They automate and optimize margin funding on behalf of their users and they support their users in all related activities (account setup, financial accounting, deposits and withdrawals etc.). Their main role however is provide a software that makes sure that lenders’ capital is always fully deployed at optimal rates. Their current focus is on US dollar lending which makes them even more attractive for traditional investors who want to have exposure in an alternative fixed income product but who are not interested in the crypto space per se. After signing up on Lendary, there is an easy-to-use onboarding guide that leads users through the account setup and provides an individual dashboard where they can monitor their lending activity. Overall, Lendary is a good example of selling shuffles to gold diggers, generating reliable, uncorrelated returns without bearing too much risk.
This article was a collaboration with Frank Steffen from Lendary. If you want to try Lendary you can sign up here.