Decentralized Finance (DeFi) has enjoyed a steady increase in popularity over the last two years. The term describes the trend to change from centralized financial markets, which are controlled by banks and financial service providers to completely decentralized financial markets, which do not necessitate any centralized intermediaries in order to grant users access to banking and financial services. This becomes possible by using smart contracts on adequate blockchain infrastructures such as Ethereum, Aave or Compound. Such smart contracts act as decentralized programs which are fueled by activity on the underlying blockchain and which will independently execute specific and predetermined actions. Users have the option to interact with these smart contracts – e.g. by transferring crypto tokens to specific crypto wallets – and thereby trigger activities of the smart contracts. Designs like these provide the possibility to automate a number of services of the finance sector. One example for this is crypto lending, in which users may receive loans in cryptocurrencies.       

How Does Crypto Lending Work?

Crypto lending is basically what the name promises: the granting of loans in cryptocurrencies. Crypto lending in the DeFi sector works without a central institution like a bank as a lender. Users may interact with a smart contract and thereby request a loan in cryptocurrency, which will be granted automatically should the specific user fulfill the requirements laid out in the conditions of vesting of the smart contract. The exact conditions of vesting depend on the individual programming of the specific smart contract. The currently existing crypto lending platforms primarily require the provision of sufficient collateral in the form of other cryptocurrencies. Due to the extreme volatility of the crypto market, the required collateral usually exceeds the equivalent of the loan considerably. Taking up a loan via crypto lending is therefore really only sensible in situations where the borrower is in need of short-term liquidity in a specific cryptocurrency and at the same time is not willing or able to sell his other crypto holdings. Taxation issues for example may make such an approach sensible. On the other hand, crypto lending is not yet suited for the temporary increase of purchasing capacity, e.g. for financing real estate, because of the necessity to provide so much collateral. This might change in a timely manner, especially in the light of the announcement of the new German Federal Government in the coalition agreement that it will commission a study to analyze the feasibility of a blockchain-based land registry. Depending on the specifics, a blockchain-based land registry may provide the option to provide collateral for crypto loans in the form of mortgages. Users obviously also have the option to provide cryptocurrencies to the crypto lending smart contract, which will then be granted as loans to third parties. They usually receive very generous interest payments in the form of cryptocurrencies from the smart contract, if they choose to do so. Liquidity risks identical to those that traditional banks have to bear arise, should the pledged collaterals of the borrowers also be lent out.  

Is Crypto Lending Subject to Authorization?

The great advantage of DeFi is the option to design financial services in a decentralized way. Therefore, there is usually no entity which would act as an operator and thereby as provider of the loan when it comes to smart contracts which settle crypto lending operations. For the purpose of financial supervision, these smart contracts are scrutinized and examined in order to figure out if there is an identifiable administrator or leading developer behind the creation of the smart contract. Those may, in specific cases, be addressees of an authorization obligation. It is also conceivable that users which provide a smart contract with cryptocurrencies in order to receive an interest payment thereby perform an activity which is subject to authorization. Irrespective of the question, if there is a responsible operator or not, regulatory obligations to obtain authorization can only be applicable if the specific activity itself is regulated. The credit business, which is subject to authorization according to the German Banking Act (KWG) only relates to loans that are granted in legal tender and is therefore not applicable to the transfer of crypto assets by way of loan. In specific cases, the administrator of the respective smart contract could be qualified as a crypto custodian and therefore be subjected to authorization because he receives, manages and safeguards crypto assets. Users providing cryptocurrencies to a smart contract based crypto lending operation on the other hand usually have no knowledge of the identity of the borrower. They therefore act solely to receive interest payments and have no intention to provide a service to a third party. They will therefore hardly be subject to authorization. 

Attorney Lutz Auffenberg, LL.M. (London)