Crypto shadow banking explained and why 12% yields are common

Non-bank lenders that accept digital assets can earn double-digit interest on shortage of traditional currencies

New York

SOME shadow banks in the US$1.6 trillion cryptocurrency market have figured out how to generate returns of 12 per cent with minimal risk: Lend US dollars to hedge funds so they can buy Bitcoin.

Some of the largest non-bank firms in cryptocurrency including including BitGo, BlockFi, Galaxy Digital and Genesis are stepping up to meet investor demand for dollars amid a long-standing wariness by banks to lend to individuals or companies associated with Bitcoin and other digital assets. In this case, they are lending to hedge funds that need cash to buy Bitcoin for a trade that is almost guaranteed to pay out at annualised returns that have recently hit 20-40 per cent.

"The people with all the money - the banks, the brokerages - they're not in this space yet," said Jeff Dorman, chief investment officer for Arca Capital Management, which specialises in digital assets. "Everyone wants to borrow dollars, but there's not enough dollars in the space. "There is a huge cash shortage."

While traditional savings accounts offer a measly 0.5 per cent in a world that has not seen interest rates rise meaningfully in over a decade, non-bank lenders that accept digital assets can earn double-digit interest due to a severe shortage of traditional currencies like US dollars and euros. The wariness of banks to lend to firms or investors for cryptocurrency use goes back as far as Bitcoin itself, with most institutions shunning an industry they saw as enabling money laundering, drug trafficking and other nefarious pursuits.

While those willing to lend cash are being paid well for the risk they are taking, the shadow banks in crypto lack Federal Deposit Insurance Corporation (FDIC) insurance and other customer protections. There is also little transparency in this part of the financial world, Mr Dorman said, adding: "All these guys are just hedge funds playing a bank on TV."

Here is how the trade works. It starts with the price discrepancy between the spot price for Bitcoin and the value of derivatives contracts that come due months in the future - what is known as a basis trade. On March 15, Bitcoin traded for US$56,089 while the July future contract on CME Group Inc was at US$60,385.

A hedge fund could buy Bitcoin at that spot price and sell the July futures, meaning the derivatives would gain value if Bitcoin fell. Doing so on March 15 locked in a 7.7 per cent spread between the cash and futures price. Annualising that over the 137 days between March 15 and July 30 when the futures contract expires equates to a 21 per cent annual return.

The hedge fund, however, needs cash to buy the spot Bitcoin, and would be willing to pay what seems to be exorbitant rate of 12 per cent for the loan as long as it can earn 21 per cent, or a 9 per cent profit, on the trade. The spread between spot and futures has been even higher in recent months.

"The basis trade was paying 42 per cent annually the other week," Michael Saylor, the chief executive officer of enterprise software maker MicroStrategy Inc who has bought 91,326 Bitcoin since December worth about US$5 billion, said March 17 at the Futures Industry Association conference.

One aspect of this trade is that it is almost risk free, assuming CME Group does not go bust as a counterparty. That is because once the spot and futures prices are locked in, they will converge so that the spread between them is the pay-off, minus trading fees.

Another indication of the lack of cash in this market is that most loans of stablecoins, which are typically backed by traditional currency reserves or a basket of other digital assets, also earn high yields. That is because stablecoins such as Tether and USD Coin are used just like cash to buy other cryptocurrencies.

The basis trade is of course controlled by the market, and the recent fall in Bitcoin from about US$62,000 to US$55,000 has caused the spread between spot and futures to narrow. If done on March 23 with the August futures contract, the basis trade would only return 13.6 per cent. BLOOMBERG

KEYWORDS IN THIS ARTICLE

BT is now on Telegram!

For daily updates on weekdays and specially selected content for the weekend. Subscribe to t.me/BizTimes