The double-edged sword of crypto lending among institutional investors

Bitcoin and cryptocurrencies are traded at all levels of investment, from the smallest retail buyer who wants to try make a few rubles to the biggest investment funds that manage millions of dollars worth at a time for their clients. The small fish like us are only really able to benefit from the ripple effects of the whales as they move giant sums of cash and crypto around, making waves in the Bitcoin price.

Some of those in between the whales and minnows, like the dolphins, are willing to take more risk by trading on margin, using exchanges that offer, for example, 20x leverage, or even up to 100x leverage, which gives huge potential for both profit and loss as the risk increases on the trade exponential to the leverage. And such options allow for both long and short trades, or the opportunity to profit if the price goes down as well as up, as long as you predict the correct direction of course.

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Now add to that the possibility of lending and borrowing of crypto assets, as the financial industry likes to call them, and you have the potential for not only whale-like action in the sea of cryptocurrency but potentially even bigger creatures like the mythic Kraken of Norse legend, that eats entire ships for breakfast. What I’m alluding to is the fact that, according to giant hedge fund managers, the lending of crypto is on the increase and is growing at an astonishing pace. And this can directly affect the prices for all of us.

These huge investment funds are currently entering the crypto market. Smart money and big traditional investment fund management companies are adding crypto to their portfolios for their millionaire clients. This adds healthy competition, pushing down fees at these investment firms but, according to insiders, overall performance has been lackluster.

The 2018 bear market forced some crypto funds out of business and fewer giant fund companies are active than we are led to believe.

Operating costs at these giant hedge fund companies have been difficult to meet, particularly as increased compliance requirements emerge. Some of them are turning to other sources of recurring income and one of those opportunities lies in crypto lending. Big hedge funds are now lending out their crypto investments for a fee. They are acting like banks.

This may boost the hedge funds, and possibly bring liquidity into the industry, but it could have other hidden risks for us all.

To set the context, let’s remember that hedge fund fees are coming down as some charge an average of 1.72% for their services, but some charge less and a few have even gone to the level of zero fees. The SEC even gave the go ahead to one asset management firm – Salt Financial – to offer negative fees. So the financial services industry is changing considerably in the contemporary market, and is being forced to adapt quickly, which leads to innovation and opportunity.

One such opportunity for income is in lending crypto. This may positively enhance liquidity in the crypto market, particularly with the growing practice of making a profit by short selling on leverage, as mentioned, and not just on going long and selling at a profit, like most of us retailers do.

However, there is also the risk of further market manipulation sneaking in here, as if we don’t already have enough of that.

In traditional markets most securities loans can be recalled at any time, and crytpo hedge funds may do the same thing. Now whether that loan was loaned out yet again to someone else, or perhaps used to make a short sell, it will have to be bought back and considering the huge amounts involved (millions of dollars at a time) this activity can push the overall price of the crypto asset up.

Now if a hedge fund manager knows this will happen and deliberately uses this strategy to boost their personal fund valuation, they could use this questionable tactic to make that profit, lock in the rewards and thereby pushing the price of the asset back down. This all adds to the personal performance of that hedge fund and thus attract more investors, but it does artificially manipulate the overall market price, particularly if short sellers on margin got squeezed out in the process.

A hedge fund can’t go on doing this indefinitely thankfully, as their reputation would precede them in the industry and no one would borrow from them any more. If they run out of business and have to liquidate their entire fund, selling all their crytpo, it may badly affect the price yet again as they dump their millions onto the market. In this way whales knowingly manipulate the open market price for all of us, minnows and other whales included.

The interesting fact is that many investors in these giant crypto hedge funds are themselves also other big institutions, who are also judged by their performance. In order to please their customers and obviously cover costs in an increasingly competitive industry, there is at present little incentive to curb such manipulative lending practices. And crypto lending in general is growing among these big players.

Regulation could come in and provide more transparency and oversight, although the debate regarding more regulation is a contentious one.

With regulators still slow and cautious to implement too much at present, it’s up to the industry to self-regulate. Is this like asking the wolves to tend the sheep? Despite blockchain making all transactions transparent for all to see on the open ledger, self-regulation is opaque and hard to implement when so much money is at stake, considering the frailties of human nature. However, in the long run it is to our advantage to have robust regulations and a smooth unmanipulated market.

Without it there could be a systemic risk if the practice is left to spread.

Even off-chain OTC trades of large amounts, including for lending, may hide the giant movements of crypto between hedge funds and institutional investment firms, including those that could cause ripples or waves in the price action down the line, considering the intertwined web of assets globally.

So crypto lending is a sharp but double-edged sword. It’s up to those on the inside of the big financial companies to really rise to the occasion and wield that sword in an exemplary way, lest it cut off their own nose because they couldn’t see further than their nose.