In this week’s newsletter, we will be discussing the shadow debt market and its connection to cryptocurrencies. Don’t worry if this sounds complex, we will break it down in a way that is easy to understand for everyone.
A “shadow debt market” is a type of financial market in which money is borrowed and lent outside of the traditional financial system. In order to get a full picture, it’s important to know how the traditional debit market works. It is also referred to as “TradFi” (Traditional Finance). TradFi is a financial market where people can borrow and lend money through instruments such as bonds and loans. People borrow and lend money from banks and other financial institutions in the traditional market, and the transactions are governed by laws enacted by governments and other authorities. Bank and financial institution authorities monitor the market, assets, and collateral and stop making loans when there is too much risk for the bank. The loan terms are recorded in private and centralised databases, which regulators can access. TradFi has learned from its mistakes in the past, such as the Enron scandal and the 2008 financial crisis, and has implemented rules and regulations to prevent future disruptions and protect investors.
The shadow market is the polar opposite of traditional finance. It lacks regulators and government involvement to ensure that everything is stable. This means that the transactions are not governed by the same rules and regulations, and they frequently employ instruments that are less well-known or understood. People in a shadow debt market may borrow and lend money using cryptocurrencies, derivatives, or other complex financial products. Shadow debt markets are frequently less transparent than traditional debt markets, making it difficult to determine who is borrowing and lending money and on what terms.
Let me give you an example. Let’s assume you plan to take out a loan to buy a home. There are two ways to go about it. going to the bank or going to a money lender who is not authorized by the government to lend.
Borrowing from a regulated bank or NBFC.
Generally, lenders in the traditional home loan market offer a standard interest rate set by the Reserve Bank of India. This standard rate helps to ensure that borrowers are not charged exorbitant interest rates and helps to keep the financial system stable. Traditional lenders frequently require collateral from borrowers, such as a mortgage on the property, to secure their investment. This collateral protects the lender in the event that the borrower fails to repay the loan. Traditional lenders may have systems in place to ensure that borrowed funds are used for their intended purpose, such as purchasing a home rather than going on a lavish vacation, in addition to requiring collateral. In the traditional home loan market, repayment is typically made through banks using transparent and standardised processes, making it easy for borrowers to make payments and allowing for updates to credit bureau data that can impact the borrower’s credit score. Overall, the traditional home loan market ensures that everyone is treated equally and provides a fair and transparent environment for all participants.
Borrowing from an unregulated money lender.
Interest rates on home loans in the shadow debt market may be higher than those set by the Reserve Bank of India. This is because lenders in the shadow debt market are not bound by the same rules as traditional lenders and can charge whatever interest rate they want. Furthermore, nonpayment of EMIs (equivalent monthly instalments) in a shadow debt market may not be reported to credit bureaus, implying that the borrower’s credit score will be unaffected by their default. This may make it easier for borrowers to default on their loans without penalty. Furthermore, in a shadow debt market, the lender may use excessive force or illegal means of intimidation to obtain repayment from the borrower rather than going through a court of law. This can create a dangerous and unpredictable environment for both the borrower and the lender.
I hope you understand the distinction between the traditional and shadow debt markets. Now that you have an understanding of how it is done traditionally, we will discuss the shadow debt market in the world of cryptocurrency.
Uncollateralized lending in the shadow debt market
It is the practise of borrowing and lending cryptocurrencies without the use of collateral. In other words, this kind of lending does not require any securities from the borrower, such as cash or other cryptocurrencies. This can be risky for both the borrower and the lender because there is no guarantee that the borrower will be able to repay the loan. However, it is a common practise in the cryptocurrency industry, where billions of dollars’ worth of cryptocurrencies are borrowed and lent in this manner. This activity is frequently hidden from public view because it is not regulated by any government or financial institution. Some of the biggest names in the cryptocurrency industry are involved in this type of lending, which can have a significant impact on the market.
The technology used in the shadow debt market
Even though there is a lot of money involved in this market, the technology is not very advanced. Instead of using modern systems to connect borrowers and lenders, people in the shadow debt market communicate and negotiate loan terms through chat groups on the Telegram messaging app. These discussions may include topics such as interest rates and loan duration.
The lack of transparency in the shadow debt market
Another issue with the Shadow Debt Market is that nothing is transparent. There is no simple way to determine current interest rates. There is no exchange where people can see what other lenders charge, and no public ledger that shows the terms of all loans made. This means that borrowers must negotiate directly with lenders, and the interest rates they pay can vary greatly depending on who they speak with and how good they are at negotiating.
When a borrower and a lender reach an agreement on loan terms, the lender transfers funds to the borrower in the form of cryptocurrency. However, the lender has no way of knowing what the borrower will do with the money, and there is no oversight to ensure that the borrower uses it responsibly. This is risky for the lender because there is no guarantee that they will receive their money when the loan is due. Lenders frequently don’t even demand full repayment of the loan balance at the conclusion of the loan term. Instead, they “roll over” the loan, allowing the borrower to keep the funds and repay them later.
Some platforms, such as Genesis, Celsius, BlockFi, and the now-defunct FTX, offered high interest rates to entice investors seeking to earn more money on their savings. These platforms have raised billions of dollars from both professional investors and ordinary people interested in cryptocurrency.
There was a lot of demand for debt in the Shadow Debt Market during the crypto bull run (a period when the prices of cryptocurrencies are rising). This is because people who had money to lend were looking for ways to make more money, and people who needed money were willing to pay higher interest rates to get it. As a result, a large amount of capital (money that can be used to make investments) flowed into the Shadow Debt Market, where it was lent to some of the biggest companies in the crypto industry, including the now-defunct Alameda Research.
The need for regulation in the shadow debt market
It is critical that the cryptocurrency’s shadow debt market be regulated by the government or another governing body. This will help to ensure the safety of money and avoid future risks and potentially catastrophic events such as FTX. By regulating the cryptocurrency’s shadow debt market, the government or another governing body can establish rules and standards that market participants must follow. This can include transparency and disclosure requirements, as well as restrictions on the types of instruments that can be used in the market.
A regulatory framework can also aid in the prevention of fraud and other illegal activities in the shadow debt market. The government or governing body, for example, could require market participants to register with the appropriate authorities and provide information about their activities. This would allow regulators to better monitor the market and identify potential problems or risks. Furthermore, the government or governing body could establish market standards for the use of collateral in order to protect both borrowers and lenders.
The recent crash of FTX and Alameda research is one possible example of the need for regulation in the shadow debt market. In this case, a sharp drop in the value of cryptocurrencies resulted in significant losses for shadow debt market investors. It was difficult for investors to protect themselves against these losses in the absence of a regulatory framework, and many suffered significant financial losses. The government or another governing body can help to prevent similar events from occurring in the future by implementing regulations for the shadow debt market.