The Silver Lining in this Crypto Crash

When crypto hedge fund Three Arrows Capital collapsed, it led to huge repercussions throughout the crypto ecosystem. Because the hedge fund had a strong reputation, lenders like BlockFi, Celsius and Voyager had lent them money and held little or no collateral to back up these loans. When 3AC went under, it left a huge hole in the balance sheet of all of these lenders. Some had to be bailed by crypto-billionaire Sam Bankman-Fried (the company he founded FTX is stepping in to buy BlockFI at a hugely reduced valuation). Others are still in trouble (for example Voyager filed for bankruptcy this week). 

The common theme among all of the companies mentioned? They are centralised lenders. They offer returns to depositors, and they use these funds from depositors to loan out crypto and earn a return on it. 

Decentralised lending protocols like Aave, Compound and MakerDAO have also had to deal with chaos in crypto markets. But they have fared a lot better. Here's why:

Overcollateralisation

Decentralised Lending works through the concept of overcollateralisation. Let's say you want to borrow some USDC and are putting up ETH as collateral. Usually, you have to put up collateral to a level of around 150%. So if you want to borrow $100 worth of USDC, you have to put up $150 worth of ETH as collateral. Now imagine the price of ETH is crashing (or don't imagine, just check the actual price which is crashing) and the value of your ETH collateral has fallen so it is now worth only $120. 

At this point, the decentralised lending protocol will require you to post more collateral, and if you don't they will liquidate your position. Because of this, the protocol should be able to recoup the whole $100 it lent you, even though the value of your collateral is falling sharply. 

Reputation means Nothing

The reputation of Three Arrows Capital means nothing to these decentralised lending platforms. They don't care who the borrower is. All they care about is making sure the loans they are issuing are overcollateralised and making sure these loans are liquidated if they are not. 

This is in stark contrast to centralised lenders who allowed 3AC to borrow on favourable terms - meaning they allowed 3AC to post little or no collateral and allowed them to post collateral using volatile, illiquid coins whose prices crashed when the bear market hit. 

We aren't out of the woods yet

This is an evolving situation. News is breaking every day and we are learning about companies in trouble. Because of this, it's too early to chalk this up as a big win for decentralised lenders. All we can say is that for now, they seem to be holding up better than their centralised counterparts.