The making of a margin lending market in digital assets?

Reported valuations of cryptocurrencies and digital assets are on the rise. Interest from professional and retail market participants alike are pushing cryptocurrency out of the fringes of financial markets and very much towards the centre. Moreover, the range of new providers coming to market via initial coin offerings (ICOs) or from those established firms and new entrants structuring financial instruments, funds and/or benchmarks referencing the underlying valuations of cryptocurrencies, have endorsed this emerging asset class even further. 2018 is unlikely to be any different in terms of growth of investments in cryptocurrencies and digital assets reliant on distributed ledger technology and transactions (DLT).

All of this is giving regulatory and supervisory policymakers grounds for concern that activity and risk, much of it unsupervised, is going amiss. Despite the concerns the process of policy and rulemaking is slow and in the absence of EU-led action has been rather uncoordinated. To further complicate matters, digital assets and cryptocurrency are far more stateless and more nimble than much of what regulatory and supervisory policymakers may be used to. Yet could this all be set to change as new funding channels fuel investments cryptocurrencies and DLT as an asset class? As 2017 drew to a close a number of statements from the European Commission suggested that 2018 might be the start of greater supervisory scrutiny and application of new uniform standards.

Financing and rulemaking go hand in hand

So whilst the emerging consensus is that, in the EU, policymakers will take primary focus at strengthening oversight and conduct of business rules in respect of cryptocurrency points of exchange as well as certain clearing houses clearing digital and cryptocurrency options, there is possibly a far greater priority at play, namely financing. Against the rise of cryptocurrency there has also come a greater interest from those looking to finance new positions and/or monetise existing holdings of cryptocurrency and other digital assets, and do so efficiently. For new participants, some of whom may be more driven by a fear of missing out, financing offers an easy(ier) way to apply credit leverage when looking to pile in to positions and/or monetise and finance further positions. That being said, not all of those offering financing to borrowers are regulated entities. And that is a problem in its own right.

With reports of cryptocurrency investors entering into unsecured (including credit card) and/or secured financing (including mortgages) to source financing in order to allocate it (often without knowledge of the lender(s)) to cryptocurrency, the risks attached to this trend is noteworthy. To further complicate matters, a rising number of these investors are likely to be retail clients as opposed to professional investors. This brings with it a number of concerns on consumer protection as well as adequacy and suitability of direct and indirect risks and how these are presented to those looking to join in. Those risks are not limited to individual firms but could be the first steps of risk propagation channels spilling over from the digital to the ‘real economy’.

This is not the first, nor the last, time that market participants will borrow to finance acquisitions nor is it uncommon for market participants, with existing holdings to lend their portfolio of financial instruments or use these as a security against a loan with contractual and operational specifics tailored to the type of security granted. In traditional European and in North American markets, this type of transaction is referred to as “margin lending”. Yet, what makes margin lending work is that the financial instruments, even if a lower liquidity profile, are likely to be located and easy to manage or divest in the event that the lender, as collateral taker of the account in which the financial instruments are held, enforces upon the security arrangements underpinning the loan.

Tokenisation and transactions

For the moment, those lending against digital assets and cryptocurrency are mostly specialised lenders and largely located in the United States and the United Kingdom. At present these are certainly not the community of wholesale market dealers mobilising billions of respective balance sheet. That being said, as demand for financing grows digital margin loans are being coupled with some further innovative adaptation of existing techniques used in financial transactions.

Some of these nascent neo-lenders are offering tokens stylised as “depositary receipts”. These aim to turn traditional assets into automated and decentralised financial instruments with a hope that this will fuel greater interest from a wider breadth of market participants and thus monetisation avenues if there is sufficient digitised assets with real-world measurable value and thus greater liquidity. Whilst financing channels have mainly focused on loans being made in fiat currency like GBP, USD, EUR and which are being extended in favour of financial collateral in the form of cryptocurrencies, possibly with some other financial instruments (equities, commodities, funds etc.), one cannot discount, especially as a result of tokenization that going forward margin lending might also wholly take place within the digital environment (i.e., extension of one cryptocurrency loan secured by a portfolio of digital assets).

Whilst tokenisation is welcome and achieves financialisation across less established markets, if done purely for purposes of driving prices and inflating (repackaged) assets rather than in a prudent manner, it might run more risk than reward for specific investors but equally across a range of exposures. This has led to the establishment of a concept of ‘tethered-tokens’ i.e. tokens that are backed by actual assets and are supposed to be ‘safer’. Yet even some of the leading ‘tetherers’ have reported that their “Asset-Backed Tokens” have been stolen. For some this may seem quite unsurprising given the corner out of which this some of this technology has come from. For policymakers it marks another example of a need to strengthen supervision and thus resilience of markets and participants.

So why has this strengthening not happened as of yet? In the absence of common global, EU and national level interpretations and/or standards, the financial regulatory oversight of FinTech, and thus a host of cryptocurrencies and a host of digital assets remains fragmented to the extent it is even regulated. On top of that comes that transparency, even amongst the more accepted and established service providers, including cryptocurrency exchanges, remains more of a desired goal.  Whilst supervisors strive for greater transparency and some may operators may welcome greater rules as a coming of age for cryptocurrency as a more established asset class, it goes against the grain of many operators. As a result, one of the key debates that the EU will face in 2018 on the resilience of the markets in as well as the liquidity of cryptocurrency and digital assets and the relevant funding channels flowing between the digital and real economy assets will be how to improve supervisory scrutiny of exchanges and access points to assets as well as funding flows.

So what is margin lending and how does it work in the traditional sense?

In a traditional sense, a margin loan is a credit facility backed by a portfolio of cash, shares, and/or units in managed funds, commodities, derivatives and/or any other form of market traded asset which is extended to individual or corporate borrowers. Margin loans are structured either for a term or a revolving facility and may be committed or uncommitted. Transactions can be structured as recourse or non-recourse loans.

A key feature is that the ability to borrow funds is determined primarily by the quality of assets in the portfolio, their Loan-to-Value (LTV) ratio, and margining and prepayment conditions along with the ability to enforce against the secured assets in an event of default on the loan. Another key feature is that in a margin loan transaction, there is no transfer of beneficial ownership. As a result borrower retains ownership of the collateral, i.e. dividends and voting control during the term of the transaction.

Consequently, a margin loan is a tailor-made over-the-counter (OTC) transaction with a high degree of flexibility that enables realisation of different strategies. Some of these include, in respect of financial instrument and a “position” in them:

  • Generating an enhanced yield or liquidity from the position i.e. “monetizing” the value of the position;
  • Protecting the value of the position;
  • Locking in future sales prices (or range of possible prices) for the position;
  • Executing a structured disposition of the position based on a desired timeframe;  and
  • Locking in financing to purchase relevant assets (whether (i) in existing portfolio or (ii) no portfolio but assets purchased then immediately stand as security against the loan.  This is often referred to as “American-Style” margin lending and/or a Lombard Loan. Both are products, which are quite well established even across retail markets.

Margin lending’s versatile and flexible mechanics make it an attractive financing channel. In the EU and in the US much of the economics of these transactions are built upon some common standards and expectations as to what the legal mechanics should entail. As a vital liquidity mechanic in financial markets, margin lending transactions are now subject to detailed regulatory and supervisory obligations that have been introduced as part of the post-2008 global financial reforms. As a product it works well where portfolios standing as security are made up of assets with stable or at least foreseeable values and there is a high degree of cost and speed efficiency in taking and enforcing security over a portfolio of financial instruments. And that is precisely where cryptocurrency as an asset class has a way to develop in terms of how a cryptocurrency, token or any other digital asset is categorised and how it is regulated.

For the moment there is discord across the EU and US as well as a host of other global jurisdictions as to how to categorise any of these digital assets for purposes of traditional regulatory terminology, i.e., as equity securities, debt securities, funds or commodities. Not all assets in the digital, but more specifically the DLT domain are designed, conceived, constructed nor perform in a similar manner. Whilst the European Banking Authority has begun some work on its regulatory approach to FinTech and created a “Regulatory Rosetta Stone” (see our client alert), an EU or global harmonised set of principles remains to be created.

Some proponents argue that the existing regulatory ecosystem is not capable of being expanded to capture cryptocurrency, DLT and the range of FinTech. Rather, a lex specialis that would operate as a lex systematis (law of the system) ought to be engineered from the ground up to govern DLT assets. This would have the benefit of not upsetting the existing lex specialis and the lex generalis governing non-DLT assets. However, with the pace of “disruption” that FinTech and DLT are becoming more prevalent, policymakers may be out of time to reinvent and must instead rather focus on rolling out the existing regulatory perimeter and supervisory tools further and in a workable manner. All of this evolution of the digital environment is necessary. It is needed not only for those offering or participating in these asset classes, but more systematically in order to improve standards and resilience especially as demand for lending and monetisation avenues in relation to these new asset classes continue to rise and financial leverage flows into otherwise narrow markets. This is particularly poignant given that these markets, absent their own specific risk channels, may become increasingly concentrated and thus be capable of being its own catalyst or spilling over into other markets and asset classes.

So, what next?

As with any financial transaction type, it is the commercial motivations and the risk/reward tolerance behind the transaction and the lack of controls that can make or break firms but also economies due to uncontrolled credit binging.  In 1929 in relation to securities, and in 2008 in relation to asset-backed securities, the “buy now, pay later” method of credit contributed to fuelling acquisitions of financial instruments that led to risk spillovers. The concept works well as long prices move upwards and from a supervisory perspective as long as investors “don’t bet the farm” – an expression that was itself popularized during the Great Depression.

The fallout of past financial crises prompted regulatory and supervisory action in relation to retail clients being able to mortgage ‘real economy’ property or buy on margin. In the United States, American style margin lending is subject to strict ratios. In the EU conduct of business and transparency obligations have been strengthened as part of implementing global standards. The pressure is certainly on EU policymakers to finalise a regulatory and supervisory environment for FinTech, cryptocurrency, DLT and ICOs. Some national authorities, notably in smaller and offshore jurisdictions have begun their own work on that. ESMA has issued, like many others, supervisory warnings on ICOs (see our briefing). Those supervisory warnings are gathering pace as the rate of ICO failures or cyber-crime incidents increase.

The pressure is certainly on EU policymakers to finalise a regulatory and supervisory environment for FinTech, as well as cryptocurrency and ICOs. Some national authorities, notably in smaller and offshore jurisdictions have begun work on that and ESMA has issued, like many others, supervisory warnings. Those supervisory warnings are gathering pace as the rate of ICO failures or cyber-crime incidents increase.

Yet, if the idea is to reduce risk-propagation in FinTech activity whilst ensuring financing does good as opposed to harm, then policy and rulemakers need to apply and adapt some existing standards and balance pragmatic solutions on how to nurture new developments and entrants. This requires more than just allocating FinTech between “good” and “bad” activity, but rather by setting common standards that are then policed. So perhaps given the role that financing and notably margin lending contribute to liquidity is now perhaps the time in 2018 to start looking at ensuring funding channels to cryptocurrency and DLT activity are subject to more supervisory scrutiny to ensure these channels and participants are resilient in light of various risks?

Michael Huertas is a counsel in the Banking & Finance practice of Baker McKenzie's Frankfurt office, focusing on helping clients navigate and realize the opportunities in the EU regulatory and supervisory framework. Michael advises national and international financial institutions, alternative investment funds and non-financial corporates on EU and Eurozone-specific regulatory and supervisory developments.
Manuel Lorenz
Manuel Lorenz is a lawyer in Baker McKenzie's Frankfurt office. He advises banks, securities firms and fund issuers on regulatory matters such as licensing and compliance as well as structuring and registration of products.