As cryptocurrency markets have grown in popularity and reach, they have expanded to unintended uses like Shadow Banking, where unregulated crypto firms provide some of the services as a regulated financial institution
What is Shadow Banking in the Cryptocurrency World?
Shadow Banking in Legacy Finance
Corporate Finance Institute defines the shadow banking system as “the broad collection of financial institutions and financial markets that offer the same type of services as commercial banks but that are not within the regulatory environment that traditional banks are subject to.” It includes, but is not limited to, mortgage lending companies, microfinance lenders, or FX money changers.
Shadow banking refers to financial institutions and markets operating outside of the same regulations as banks.
A similar practice has emerged with cryptocurrency because there are few regulations that the technology faces.
High fluctuations in cryptocurrencies, increases in scams and scammers, and missing regulations and structure make shadow banking with cryptocurrency a high-risk, high-reward activity.
What is Shadow Banking in Cryptocurrency?
Cryptocurrency is still mostly unregulated, so many legacy financial institutions remain reluctant to provide financing for digital assets as collateral.
Hence, speculators and investors are resorting to shadow banking cryptocurrency firms and exchanges to provide leverage. According to Business Times, hedge funds will take out loans to purchase cryptocurrency spot and sell futures to take advantage of basis opportunities. In the right circumstances, this can lead to a substantial profit for both the borrower and the shadow banker.
Matt Levine from Bloomberg.com describes another form of shadow banking in the crypto world. Celsius, a famous so-called “Crypto Bank,” offered extremely lucrative weekly interest payments in exchange for users to deposit their Bitcoin, Ethereum, or Tether with the lender, who then lent out the cryptocurrency to borrowers for even higher rates.
The high deposit rates of up to 18% attracted over $25bn worth of retail and institutional investors but famously collapsed in July 2022 as a result of falling cryptocurrency prices, extremely risky lending practices, and allegations of fraud.
Benefits of Shadow Banking in the Crypto World
So why do people use Shadow Banks when it comes to cryptocurrencies?
Various benefits can arise from shadow banking. The main appeal that comes from shadow banking in cryptocurrency is simply profitability.
Borrowers can use the leverage provided by shadow banks to successfully arbitrage, and the profits are amplified. It also means that the investor or speculator doesn’t need to put in as much cash as if they were to fully fund the trade themselves.
Another aspect is the high returns offered by these shadow “crypto banks.” For example, before it went bankrupt, Celsius was offering up to 18% for holders of various cryptocurrencies to place their holdings with Celsius and accept payment in Celsius’s own token, CEL.
Aside from the profitability, these shadow banking entities provide access to lending options that might not otherwise be available. For example, there may be borrowers who do not have adequate collateral to offer to traditional lenders, but they may have cryptocurrency to offer instead.
For many cryptocurrencies, there is a higher risk since their value can fluctuate considerably, so legacy financial institutions are rarely willing to lend against cryptocurrencies.
Another alluring reason for crypto investors and speculators alike is the fact that shadow banks fall outside the scrutiny of regulators, making them more censorship-resistant. Whereas traditional financial institutions will require stringent KYC onboarding requirements and possibly regular reporting, shadow banks don’t have the same mandate legally.
As many shadow banks fall outside of any jurisdiction, they may also be attractive to those who might not want to draw attention to their finances.
There are several risks associated with shadow banking in cryptocurrency, including:
1. Lack of Oversight
Since these shadow banks operate outside of traditional banking and financial regulators, they are not subject to the same scrutiny as, say, a bank is. While oversight means that banks must adhere to certain requirements, such as liquidity and capital, the lack of these requirements for shadow banks means that lenders and depositors to these entities face more risk.
Worse still, the shadow banking entity may be a scam that is simply meant to defraud investors, so one must carefully vet the crypto shadow banking entity that they choose to do business with.
2. Risky lending practices
As we saw with the Celsius bankruptcy, the high returns promised to lenders of cryptocurrencies meant that the “crypto bank” lent to borrowers who put on leveraged speculative bets or took on risky investments directly. Traditional banks have well-defined risk parameters that are required by regulators and investors to ensure that lending practices are not too risky.
Thank you for reading CFI’s guide to Shadow Banking and Cryptocurrencies. To keep learning and developing your knowledge base, please explore the additional relevant resources below: