Why Liquidations Are Needed and How They Protect Us All

If the current COVID-19 pandemic has exemplified one thing, it is that our individual actions might have dire consequences for all of us. Unfortunately, human nature propels the majority of humankind to put their individual interests first and it truly takes a severe crisis to open up our eyes to the interconnectedness of everything.

Of course, the crypto markets and the blockchain space are not resistant to the general forces that rule everywhere else. The unprecedented meltdown of prices across crypto assets with BTC shedding as much as 47% of its value intraday on March 12–13, 2020, calls for a rigorous analysis of the most recent events and an explanation on how Nexo did what it had to do to protect its customers.

It is through assessment of real-life stress-testing that the blockchain industry’s collective immune system develops the necessary resilience and this is of the utmost importance as the world’s total unpreparedness for the COVID-19 threat clearly showed.

This post examines the crypto lending space in which Nexo takes a prominent place but the conclusions can be projected to any asset-based lending business and any digital assets institution throughout the world.

Crypto Lending 101

Any significant crypto lender has two major lines of business:

1. Crypto-backed lending — clients top up crypto assets as collateral with a crypto lender in order to receive a loan. This happens without any credit checks, as the loan is secured by the underlying collateral.
2. Earn interest products — clients add funds to their accounts with a crypto lending company in order to earn interest on their idle assets.

While some companies might use the funds received on ‘Earn Interest’ products for a myriad of trading strategies and directional bets on the market, the general case states that a crypto lending institution should be using the funds received from ‘Earn interest’ products to finance crypto-backed loans for their customers.

Knowing what the company that you are entrusting your hard-earned cash with is doing and how it protects your assets makes all the difference for your financial success, especially during times of immense volatility.

At Nexo, we are completely transparent as to what we do with the funds clients are earning interest on — we finance crypto credits secured by 200–500% of collateral.

The reason we are the digital assets institution of choice for crypto-backed lending is simple: Nexo has developed fully automated lending and collateral management capabilities that can handle a large number of loans with near-instant execution in 200+ jurisdictions around the clock. The fact is that automated online credit facilitation is no simple matter, and we have been doing it successfully for more than 13 years now. We believe this is the main differentiating factor and reason why more than 650,000 users entrust Nexo with their assets.

Let’s Talk about the Elephant in the Room — Liquidations

It is our hope that you, a savvy enough individual to take an interest in crypto, someone equipped with the mindset to encompass the crypto lending business model in its entirety, will appreciate the fact that an enterprise such as Nexo is at all times protecting the interests of both the borrowers and the people funding the loans, i.e. those earning interest on their assets.

Let us unequivocally state: We do not enjoy liquidating clients as this brings them great distress and there is nothing we like to see less. Nexo’s revenues and NEXO Token holders’ dividends* are generated by the interest our clients pay on their loans, therefore liquidations go against the very essence of our business and token models as they shrink the loan book and reduce revenue.

Still, we have a fiduciary duty to everyone involved with Nexo. Considering that there are no credit checks for our products, the collateral that borrowers pledge in order to receive a loan is what guarantees the funds of those clients earning interest on their assets. The entire Nexo loan portfolio is overcollateralized by a factor of 200–500% which is what makes Nexo’s ‘Earn Interest’ product arguably even safer than banking deposits which guarantee funds only up to €100,000 in the EU, and only up to $250,000 in the US. It is important to note that Nexo’s protection mechanisms apply to any amount and are not capped.

Consider these two types of entities:

1. An institution that transparently says to its loan customers — “if the collateral backing your loan drops below a certain point and you do not add more collateral or repay part of your loan, we will need to automatically liquidate your assets in order to ensure that the people who have funded your loan do not lose their funds” VS.
2. A company that takes no interest in price volatility and tells its loan customers that they can take their time to top up their collateral or repay their loans, as there will be no liquidations in the meantime even when the collateral becomes insufficient to cover their outstanding loan.

Would you ever consider entrusting any form of money to the second company? Of course, you would not.

If for some reason you still decide to place your funds with them, imagine the following scenario: A borrower takes a $100,000 loan against BTC but the price of BTC drops and the collateral is now worth merely $20,000. This loan is entirely funded by your money. How incentivized do you think the borrower would be to repay the loan at all and how protected would your savings be?

The truth of the matter is that a crypto lending company that does not issue price-based margin calls and does not liquidate collateral automatically most probably does not have working collateral management and liquidation engine systems at all. Not liquidating collateral efficiently and on time for loans that are underwater is basically betting the entire enterprise and by extension, all the customers’ funds. Masquerading the lack of liquidations as an act of goodwill towards its clients would be audacity of the highest caliber, as it is quite simply making a risky bet on the price of crypto assets. In the instance of March 12–13, 2020 such a bet worked out as the market quickly recovered. But had prices continued to decline, the company and its clients would have been wiped out at even lower prices.

Why Does Nexo Care If Another Company Blows Up?

For a number of reasons — predominantly because we are taking the long-term view and do not want people in our still nascent industry to lose any of their assets. And without price-based liquidations of collateral, this is bound to happen sooner rather than later. Аs anyone who has ever visited a casino knows all toо well — play long enough and you will lose everything. The free drinks equivalent of the casino in our example above are the few percent of interest that are being “paid back to the community” by such companies in order for them to keep on making risky bets with your hard-earned assets until the bubble blows up.

Unlike traditional financial markets, where bailouts by governments might reduce some of the systemic risks, the ramifications of such a blowup in the crypto space go well beyond just the individual losses — they are detrimental to crypto lending and the entire blockchain community. It gives legislators, politicians and those failing to recognize the benefits of distributed ledger technology further excuses to stifle innovation and to prevent the mass adoption of crypto by pointing out the deficiencies and the foul play of irresponsible actors. We have seen this time and again with every instance of something going wrong in the crypto space.

If the blockchain space and crypto finance are to grow beyond being a boutique, niche industry of a few hundred billion dollars, all major drivers of the space need to adopt proper fiduciary governance and the space needs to institutionalize. Only this will ensure a large influx of people coming to realize that in light of the money printing bonanza and the distorted market principles that proliferate our economies today, crypto is part of the possible solution to not only preserving your current wealth but managing and growing it.

*Please be aware that the NEXO Token Dividends program was replaced with the Daily Interest on NEXO Tokens mechanism following a proposal and subsequent Governance Vote which took place in June 2021. Since June 8, 2021, the NEXO Token no longer yields dividends, but rather those who hold the asset on the Nexo platform receive daily interest payouts of up to 12% p.a.