BitLendingClub Closing and the Real Risks of p2p Bitcoin Lending

Bitcoin.com reports today that "Regulatory Pressure Forces BitLendingClub to Close," citing a letter to customers that said “regulatory pressures” have burdened operations and “it is no longer feasible to maintain” the service. 

“We’re extremely sad to be delivering this news, but that’s the reality of operating a business in the Bitcoin ecosystem. There are regulatory pressures, which make business extremely difficult and we have always done everything possible to be compliant with regulators. Given that we’ve reached the point where it is no longer feasible to run the platform and be compliant, we have decided to terminate the platform.” 

On the face of it, this is a story that resonates well within the crypto community. As Bitcoin and other cryptofinance ventures become increasingly popular, legal frictions will surely increase. But are compliance costs all that haunt p2p Bitcoin lending?

Bitcoin Lending is Plagued with Fraud

BitLendingClub, BTCJam, Bitbond, and other services that operate across the globe have to deal with multiple legal jurisdictions, many of which simply do not protect private property rights. This is an issue for any multinational business, but is particularly acute for cryptofinance firms that operate in gray legal status.

Bitcoin is not recognized in most jurisdictions around the world as legal property, so suing for restitution against fraud is problematic. Further, banking is highly regulated in most countries, and so the informal lending of companies like BitLendingClub is, at best, outside legal protection; at worst, such activity is actually illegal in a lot of countries. 

All of this makes p2p Bitcoin lending a scammer's dream. There are two ways to play the game, and each significantly increase the cost for anyone actually trying to use the market for legitimate business:

1. Take the proceeds from your first loan and run. As such a scammer, you don't care about interest rates because you have no intention of repaying, so you'd be willing to negotiate anything. This crowds out legitimate borrowers who are not willing, or able, to repay at any rate.
2. More patient scammers play a repeated game and realize they can repay a number of small value loans up front, build their reputation score, then default on higher value loans in the future. This type of scammer erodes the value of the reputation system and so increases frictions and costs. 

Even when defaults are in jurisdictions that respect property rights, including cryptocurrencies, the size of loans and the expected restitution value (accounting for time, resources, and likelihood of successful ruling and collection) is generally nowhere near large enough to justify pursuing court action. In effect, this judicial minimum cost to play sets a de facto hurdle that removes legal protection from p2p Bitcoin lending. 

The Economics of Bitcoin Lending Don't Yet Make Sense

There are three big economic factors working against Bitcoin lending at the moment:

1. Bitcoin returns are extremely positively skewed, and repaying an asset that goes up so fast, an average of 10% per month, is difficult.
2. The global economy doesn't yet have a big Bitcoin ecosystem. It is rare for individuals or businesses to get paid in BTC, so repaying BTC-denominated loans requires going back to the market to convert fiat to BTC.
3. Default premiums are astronomical.

The high positive skew of BTC returns makes borrowing it extremely costly, definitely much costlier than borrowing in the traditional financial system. Of course, not everyone around the world has access to a well developed financial system from which to borrow, so there's a case for BTC lending to work in these markets. 

The problem is that the extreme positive return skew plus the cost of fraud prices out most legitimate businesses. If the real cost of BTC borrowing is something like 50%, is that something a Ugandan farmer looking to borrow for a seed investment can feasibly repay on a continuing basis? The farmer almost definitely sells his crop for local fiat, which requires future conversion to BTC at, on average, higher price and with nontrivial transaction cost in thinly traded markets. This makes it nearly impossible for such a borrower to repay, even with the best of intentions. 

Caveat Emptor

Everyone has the right to invest their own money however they want, and p2p lending is part of the new cryptofinance industry. What's important is that people understand the real risks they're taking. p2p Bitcoin lending is much riskier than USD p2p lending with something like Lending Club. The U.S. has a highly developed financial system with legal protections against property crimes. Further, you have a lot more information, such as credit scores, with which to make decisions. Building a credit score reputation takes years and can be undone with a single default, so there are much higher barriers to fraud. These do not yet exist in p2p Bitcoin lending. 

Besides fraud risk, the economics just don't yet make sense relative to the use of funds that can earn sufficient return to make repayment. The highly positive return skew and significant market frictions likely increase the cost of such lending relative to legitimate economic uses of funds. 

What are your thoughts? 

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Rob Viglione is a PhD Candidate in Finance @UofSC with research interests in cryptofinance, asset pricing, and innovation. He is a former physicist, mercenary mathematician, and military officer with experience in satellite radar, space launch vehicles, and combat support intelligence. Currently a Principal at Key Force Consulting, LLC, a start-up consulting group in North Carolina, and Head of U.S. & Canada Ambassadors @BlockPay, Rob holds an MBA in Finance & Marketing and the PMP certification. He is a passionate libertarian who advocates peace, freedom, and respect for individual life.  

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Image source: http://www.newsbtc.com/2015/03/19/a-simple-guide-to-bitcoin-loans/