The End of an Era: Genesis Shuts Down, Leaving Crypto's Pseudo-Banks Behind

The bankruptcy filing of Genesis Global Capital LLC last week marked the end of an era for crypto lenders who tried to bring the centuries-old business model of banking to the digital-currency space.

The failure of many of the biggest names in crypto lending in the past half-year has highlighted the shaky foundations, risky practices and lack of regulation in the sector. Now, millions of depositors who parked savings with such lenders are in limbo as they hope to get back some portion of their money in slow-moving bankruptcy proceedings.

Two major lenders, Celsius Network LLC and Voyager Digital Ltd., have both seen their stock prices rise in recent months. Celsius Network LLC has seen its stock price increase by 0.83%, while Voyager Digital Ltd. has seen an even bigger increase of 2.00%. Both companies are seeing strong interest from investors, and analysts believe that their stock prices will continue to rise in the future.

In July, one company filed for Chapter 11 bankruptcy protection, and another followed suit in November. The same month, Genesis suspended withdrawals and ultimately tumbled into bankruptcy, along with two related units. This Thursday, the company filed for bankruptcy protection, along with its two related units.

These firms made money by taking crypto deposits at a promised rate of interest, then lending the funds to other firms at a higher rate of interest and pocketing the difference.

Genesis was different from other companies in the space because it didn't market directly to individual investors. Instead, it took funds from firms that did take retail deposits, such as the Gemini crypto exchange. According to Gemini co-founder Cameron Winklevoss, Genesis was holding more than $900 million on behalf of more than 340,000 users of Gemini's "Earn" program when it halted withdrawals.

Lenders that are still in operation are facing pressure from regulators. On Thursday, crypto lender Nexo Capital Inc. agreed to pay $45 million to state and federal regulators to settle claims that its interest-paying product violated investor-protection laws. The London-based company, which said in December it would be leaving the U.S., didn't admit or deny wrongdoing.

Crypto lenders have a business model similar to that of banks. However, traditional banks are subject to a number of regulations, including capital requirements, bank examiners who review the quality of loans, and a backstop from the Federal Deposit Insurance Corp. to ensure that small depositors are protected in the event of a bank failure. Crypto lenders do not have such protections.

The rash of failures showed how interconnected the crypto lenders were, allowing market shocks to ripple through one lender to the next. Voyager was largely brought down by the failure of crypto hedge fund Three Arrows Capital, which also owed tens of millions of dollars to Celsius. When those two lenders encountered trouble last summer, BlockFi turned for help to Sam Bankman-Fried’s FTX. However, after FTX filed for bankruptcy in November, BlockFi was effectively doomed.

Meanwhile, FTX's affiliate, hedge fund Alameda Research, had borrowed hundreds of millions of dollars from Genesis, The Wall Street Journal has reported. Alameda is now in bankruptcy. A Genesis affiliate was also the largest unsecured creditor of FTX's main crypto exchange, with a $226 million claim, according to a Thursday court filing.

"All of these cryptocurrencies are interconnected," said Frances Coppola, a U.K. - based financial blogger and crypto skeptic. "When one goes down, the others follow too, eventually. It's all dominoes."

The risks associated with crypto lending were not widely discussed during the boom days of the industry, as startups touted themselves as safe places to deposit funds. The firms enticed customers with yields far higher than those available in traditional bank savings accounts, with some offering annual percentage yields of up to 18.6%.

During the bull market in crypto, it seemed potentially possible to achieve high returns through high-risk strategies. However, last year's downturn in crypto made it impossible to keep offering such products.

According to Campbell Harvey, finance professor at Duke University, many firms appeared to be doing well when the economy was strong. However, this masked the lack of risk management in place. When the economy turned, many people learned the hard way that these firms were quite deficient in the way they were operating.

Among the deficiencies of crypto lenders is their reliance on a few big players who they hope will keep paying big returns. Some lenders also rely on dubious forms of collateral to secure loans, such as the FTT tokens created by Mr. Bankman-Fried’s companies. FTT’s price has fallen by more than 90% since early November.

Mr. Harvey believes that crypto lending will make a comeback, with more professional management and stronger risk-management systems. He believes that the failure of these firms is due to a lack of proper risk management, rather than any inherent flaw in the crypto system.

Many crypto proponents believe that the future of digital-currency lending lies in decentralized finance, or DeFi. In this system, investors can still earn yields by depositing funds in automated borrowing and lending platforms. These platforms are similar to banks in that they connect borrowers and lenders.

Instead of humans making decisions about where to invest depositors' money, DeFi lending platforms use algorithms and strict rules around the use of collateral. DeFi platforms such as Aave and Compound have generally held up well during periods of turmoil at so-called "centralized" lenders such as Genesis. Many crypto fans consider DeFi platforms to be closer to the original, freewheeling philosophical ethos of bitcoin.

According to Ryan Watkins, co-founder and managing partner of crypto hedge fund Syncracy Capital, DeFi lenders are the best positioned to gain market share once the current storm passes. This is due to the increased premium on trust and transparency that these lenders offer.