Introduction
In traditional markets, ratings agencies provide a core function which enables market segmentation, allowing investors to make informed decisions based on risk appetite. The relationship between credit ratings and interest rates is direct and significant. Higher rated issuers pay lower interest rates on debt, reflecting the lower risk of default. As ratings decline, perceived risk increases, and investors require higher interest rates to compensate.
This behavior is clear in the figure below, where effective interest rates across S&P Rated Bonds show a clear discrimination, obtained from the FRED database.
Crypto credit market borrowing demand has historically been dominated by trading firms looking to improve their capital efficiency. Lenders have included the now bankrupt centralized lenders (Genesis, BlockFi, Celsius etc), credit funds and high net worth individuals (often via on-chain protocols).
According to Credora analysis, throughout 2021 and 2022, there was limited evidence of the market pricing relative credit risk across borrowers. At this time, Credora was unique in providing standardized credit risk metrics for a segment of borrowers. In all markets, standardized credit metrics help maintain efficiency and stability, facilitating capital allocation. The pricing behavior is reflective of an immature credit market. Although the market has evolved since 2022, the immaturity presents a huge opportunity for further development.
This analysis combines Credora’s rated firms dataset with publicly available lending information. It demonstrates that historically, there was no evidence of the market uniformly pricing credit risk according to Credora’s rating scale.
First, we compared historical crypto market rates with the observed rates in traditional credit markets. This comparison provides insights into how the market perceives the risk of lending to trading firms over a period.
To get a view of the different credit risk across crypto trading firms, this dataset is enhanced with Credora’s historical credit score information.
While there is limited delineation in pricing for crypto trading firms based on credit risk, there does appear to be a minimum threshold rating to access loans. Those rated below a B by Credora were not publicly able to access credit.
It is possible that a stronger determinant in the pricing of loans over the period were factors such as lender incentives and market activity. The following are hypothesis for why the data shows limited evidence of pricing the relative credit risk of firms:
Incentives for the largest lenders.
- Principal lending businesses, including Genesis, BlockFi, and Celsius, were the largest lenders throughout 2021 and 2022. These lending firms were highly incentivized to maximize the deployment of capital. As a result, the clearing price for loans was more significantly influenced by the underlying supply and demand of the market (availability of capital and the expected return for borrowers).
Utilization of limits as the core tenet of risk management.
- From Credora’s historical experience, it was evident that risk analysis primarily influenced the size of a credit line for a specific firm, rather than the interest rate. Effectively, large lenders made binary decisions regarding whether or not to lend to a specific counterparty at the prevailing market interest rate. Relatively higher quality credit counterparties were allocated more loans, while weaker counterparties could only access a limited amount of capital.
Variability of demand.
- As trading firms were the primary borrowers in the market, short term trading opportunities had a significant impact on demand. This was demonstrated by large variations in the average loan rate, despite relatively smaller changes in underlying creditworthiness and macro conditions.
As relatively small sources of capital at the time, on-chain debt protocols were in no position to have major influence on market structure and dynamics. Regardless of the underlying analysis performed and potential risk segmentation, it was difficult to deploy capital at interest rates which materially deviated from the prevailing market rate.
Conclusions
Historically, the crypto credit market shows limited evidence of a higher interest rate paid by relatively weaker credit borrowers, which indicates that the market did not significantly differentiate risk through pricing.
Borrowers rated by Credora with a B or lower were not able to successfully access capital, indicating there is indeed a relationship between loans and creditworthiness, but in more of a binary nature.
This analysis underscores the early stages of the digital asset credit market, highlighting a critical need for uniform credit scoring standards. Credora is focused on filling this gap, providing standardized and systematic credit assessments for crypto trading firms and other borrowers. We view this as a requirement for restored confidence in on-chain credit markets, especially as this infrastructure shows increasing promise for the future of private credit.
It also sheds light on a significant gap in the thoroughness of credit underwriting practices amongst lenders, particularly throughout the years 2021 and 2022, which was evident in the large losses incurred by many. Simply, the risk of lending to multiple reputable borrowers (at the time), was severely miscalculated.
Finally, it’s worth noting that since this period, we have seen meaningful responses by the market to improve standards in analysis, deal structuring, and transparency. We are optimistic that this will continue, and that a historical analysis of 2024 will show meaningful differences.
