An unbalanced sheet—Explainer on the asset-liability mismatch in crypto lending firms

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In recent months, several crypto lending firms such as Celsius and Vauld have frozen deposits in the wake of plummeting values of cryptocurrencies. Experts, however, have flagged concerns over the business model of yield-generating crypto firms as reports of asset-liability mismatches have come to the fore.

Crypto lending platforms allow customers to buy, lend or borrow and trade crypto assets or tokens. On the face of it, the business seems like the traditional banking business, with customers opening accounts, and the platform offering collateral-backed loans.

While an asset-liability mismatch is not a new phenomenon in the crypto sector, a look at the balance sheets of firms like Celsius offers insights into the reason crypto lending firms are particularly susceptible to an unbalanced balance sheet.

What does an asset-liability mismatch tell us about the business?

When a businessman buys/produces goods or services, he finances the cost by either taking a loan or infusing the business with his own money/equity, which are treated as liabilities. When the business earns a profit, it is held as cash in the assets column and an equal amount is transferred to the equity column. Therefore, in principle, the assets side of the balance sheet should be equal to the other side comprising liabilities and equity.

Even though the equation holds in theory, past instances of asset-liability mismatches have been seen in cases such as in the collapse of Punjab and Maharashtra Co-operative (PMC) Bank. For banks such as PMC, deposits by consumers are held as liabilities while the loans given out form a part of the company’s assets. It was later discovered that the bank had advanced money through fictitious accounts, creating a situation of a mismatch in assets and liabilities.

Apart from the value of the assets and liabilities, the duration should also match to achieve a balanced balance sheet. If a bank funds its long-term loan disbursals with short-term deposits, it could lead to an asset-liability mismatch when the depositors call back their funds which may been loaned out for longer terms.

Banks, however, are in the business of growth. This cannot be achieved by completely aligning the duration of debt and assets. Cheap sources of funds like CASA or current account, savings account, meaning the money depositors keep with banks, enables banks to borrow cheap and lend at higher rates, making it a profitable business. To achieve this, banks depend on trust that depositors place in them.

How is the asset-liability mismatch playing out in the Web3 world?

Like banks, crypto lending firms such as Celsius and Vauld are in the business of yield generation. Taking advantage of the so-called grey areas in the crypto regulations (or their lack) in India, crypto firms like Vauld lured retail investors in India to deposit or stake cryptocurrencies on their platforms, offering in exchange returns as high as 12.68 percent. This asset class was labelled as the crypto fixed deposit, a high-return alternative to the traditional bank-based fixed deposits, and marketed by crypto lending firms through financial influencers on social media platforms like YouTube.

Vauld, however, froze all customer deposits on June 4. The company, in its blog, cited excessive customer withdrawals and the collapse of other crypto platforms like Celsius amid the rapid fall in the value of all major cryptocurrencies.

The situation as described by Vauld in its blog is similar to what is referred to as a run on banks in the traditional financial space. When a bank loses the trust of its depositors, they flock to withdraw their money.

Even though crypto lending institutions earn profits by increasing their net interest margin (NII) —the difference in the costs of borrowing and the return on lending—a closer look at their balance sheets underlines the risks of yield generation unique to the crypto lending space.

According to the report by blockchain analytics company Arkham on the Celsius Network, which was compiled using publicly available information about the company, the crypto lending platform earned revenue through diversified sources. Some of these sources, such as lending to both retail and institutional borrowers, were similar to the revenue models of traditional banking institutions.

Other sources of revenue were crypto-specific such as investing funds in decentralised crypto exchanges that enable crypto traders to directly buy and sell their cryptocurrency without a centralised party. Individuals and institutions lock their funds in decentralised exchanges in order to earn a return.

Although at first glance it appears that the crypto lending institution’s revenue sources are diversified, the business of high yield generation becomes riskier when the volatility of cryptocurrencies is factored in.

In an event where cryptocurrencies are shedding value in a falling market, investors might resort to pulling out their deposits which the crypto lender might have in turn lent to another institution or retail investor.

At other times, the crypto lending institution may borrow in one currency and lend in another. If the borrowed currency rises in value, the cost of funds also rises for the institution.

Apart from the volatility, crypto exchanges are also vulnerable to hacking. In December 2021, the Celsius Network lost money on DeFi or decentralised finance application BadgerDAO due to such a hack, according to an interview by Celsius CEO Alex Mashinsky.

Crypto lending institutions also borrow cryptocurrencies from blockchain platforms where the firm has to pledge an amount greater than its borrowing as collateral. Celsius had borrowed from a similar on-chain platform called Maker, where the firm had to maintain certain collateralisation to debt ratio, failing which the pledged assets could be confiscated.

On July 7, Celsius was faced with such a situation when it was forced to tap into its liquid funds to repurchase its collateralised assets using funds that would otherwise have been used to repay depositors.