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Direct Lending vs Private Credit in Cryptocurrency

Funding matters to kickstart any business, but what about Web3? This blog discusses the difference between direct lending and private credit in cryptocurrency.

Gluwa marketing

Nov 10, 2023 • 11 min read

As the crypto industry continues to mature and expand, new financial services are constantly being integrated and brought on-chain. One of the biggest financial verticals already seeing large-scale adoption is private credit, and more specifically, direct lending.

This article will explain what private credit and direct lending are, as well as the differences between them, before highlighting major examples of private credit adoption in crypto including DeFi, outline the benefits of distributed ledger technology for private credit, and finally, discuss how you can get involved in direct lending in crypto today.

Cryptocurrency has become a widely embraced financial phenomenon across the globe. Direct lending allows individuals to lend money directly to one another, eliminating the need for intermediaries. Tokenized loans in private credit enable borrowers to obtain funds conveniently.

Key Takeaways:

You will learn about the key differences between private credit and direct lending.
Understand how distributed-ledger technologies are helping to improve private credit markets.
Discover notable examples of private credit and direct lending in crypto, including DeFi.
Explain how you can access various direct lending opportunities in crypto, including fintech credit investments and P2P over-collateralised lending.

What is Direct Lending?

Direct lending is a form of private credit that involves providing loans to companies directly, without the use of intermediaries such as a bank.

It is by far the largest subset of private credit investment today, differing from more specialized types of private credit such as distressed debt, and is usually common with companies unable to obtain credit from traditional banks (usually small to medium-sized enterprises).

Direct lenders are typically institutional investors, such as private equity firms, pension funds, and hedge funds, as well as wealthy private investors.

Oftentimes, parent companies will also engage in direct lending to their various portfolio companies.

For example, high-growth startups with a negative cash flow are often unable to raise debt from banking institutions due to risk mitigation regulations.

As a result, these businesses can represent a high-risk high-reward target for direct lenders willing to bet on a company's future revenue streams.

Unlike traditional lending, where debt is often syndicated across various parties, direct lending is usually concentrated in one or a handful of private investors.

Given the specialized nature of direct lending, with limited ability to trade these loans on secondary markets, direct lending loans often feature more flexible rates, and higher premiums, and are usually held to maturity.

The specialized and flexible approach of direct lending, occurring within smaller and tighter networks of investors and other syndicated parties, can help to increase the chances of reaching repayment and debt restructuring agreements in cases of loan difficulty, helping to mitigate default rates.

On the flip side, private credit managers with fewer reporting requirements may be more willing to let troubled companies extend their loans to avoid writing off debt from their balance sheets. BlackRock covered an insight into the growth of direct lending in 2023.

What is Private Credit?

Private credit is a broad term that encompasses all types of debt financing provided outside of the traditional banking system. This includes direct lending, as well as other types of debt investment, such as mezzanine financing, structured debt, and specialty finance.

The private credit industry has seen rapid growth since the 2008 financial crash, when regulators began imposing stricter controls on the types of debt investment banks could make to minimize the risks banks could take onto their balance sheets.

As a result, non-bank lenders have increasingly stepped in to fill the void, offering loans and specialized financing solutions to borrowers whose credit structures or financing needs may disqualify them from a traditional bank loan.

Private credit lenders are typically willing to take on more risk than traditional banks, and they can offer more flexible and bespoke financing solutions, making private credit an attractive source of capital for borrowers. These factors have contributed to the rapid growth of private credit globally, with the industry growing to $1.6 trillion in assets under management today.

However, private credit investments are often riskier and less liquid than their traditional counterparts, with investments difficult to refinance or trade on secondary markets. Of course, this also means that private credit markets can often result in greater rewards for investors and lenders too.

The most common originators of private credit investments are private credit funds, pension funds, hedge funds, and other specialized non-bank financial institutions, as well as wealthy private investors.

Top 5 Differences between Direct Lending and Private Credit

	Private Credit	Direct Loan
Scope	Includes various non-bank debt financing types like mezzanine and venture debt.	Specifically offers loans directly to companies, usually secured and senior in the capital structure.
Borrowers	Serves a wide array of borrowers from different sectors and sizes.	Often targets middle-market companies with EBITDAs between $10 million to $250 million.
Flexibility	Provides flexible, regulation-light financing that varies by industry and loan type.	Offer flexibility too, but generally less so than other private credit forms.
Risk	Risk ranges from low (asset-based lending) to high (distressed debt); regulatory lightness adds opacity.	Riskier than bank loans due to higher borrower debt levels but are secured by collateral.
Liquidity	The investments are not easily traded, being highly tailored to the borrower's needs.	Somewhat more liquid through syndication but still less so than public market instruments.

Most Recent Stories in Direct Lending and Private Credit in Crypto

It's hard to overstate the role of private credit and direct lending in crypto today, with the dramatic volatility of the industry largely explained by to scale of debt, leverage, and indeed, private credit, involved.

But with such a wide confluence of traditional finance, fintech, venture finance, and the revolutionary technology of DeFi all mixed, it's important to distinguish between the types of private credit in crypto.

Decentralized Finance

Decentralized finance, or "DeFi" as it is commonly known, is synonymous with DeFi lending, a form of direct lending in which borrowers and lenders interact directly without the need for intermediaries such as banks.

As of today, there are around $10 billion in crypto assets currently locked in DeFi lending on Ethereum alone, with several other blockchains also featuring their own DeFi lending protocols.

DeFi lending protocols work based on two principles.

Firstly: Smart contracts enable the automatic execution of on-chain agreements.

Secondly: DeFi protocols use over-collateralization to minimise counterparty risks.

In conjunction these two elements allow users to lend and borrow crypto in a decentralized environment without the need for a bank or third-party institution. These protocols have proved remarkably resilient during wider market downturns, protecting lenders through automated on-chain liquidation of a borrower's collateral.

Traditional Private Credit

Given the investment restrictions placed on banks and wider uncertainty over crypto, private credit has become a central pillar of financing in today's crypto industry. Indeed, a wide variety number of entities, including crypto exchanges, venture capital funds, and more, engage in various forms of private credit borrowing or lending within the crypto sphere.

For example, many companies with revolving revenues use private credit to fund short-term expansion. For example, Marathon Digital secured around $100M in financing to expand its crypto-mining operations in 2021.

Nevertheless, given the lack of public reporting requirements in private credit, it can be difficult to identify good public examples. Despite this, the scale of private credit was laid bare for all to see in 2022 when the crypto market collapsed.

We've given some of the biggest examples below:

Three Arrows Capital

Three Arrows Capital (3AC) was a prominent crypto hedge fund that raised private debt from several crypto-native, and other, companies to fund its trading and venture operations.

When the crypto market took a turn for the worse, in particular, the collapse of UST, Three Arrows Capital was forced to file for bankruptcy, with creditors including Genesis, BlockFi, Voyager Capital, FTX, and many more incurring losses.

FTX

FTX was the world's second-largest cryptocurrency exchange, founded by the recently convicted, Sam-Bankman Fried. Alongside its exchange operations, the company also engaged in various forms of direct lending to other crypto-native companies including Three Arrows Capital.

When 3AC collapsed, FTX tried to stem the contagion by providing distressed financing to various companies including a $500m line of credit to Voyager Capital. This, alongside, other cases of corporate mismanagement, resulted in the company's eventual collapse and bankruptcy.

Not only did FTX take on several poor-quality loans, with a number of its private credit investments turning sour, but they also used depositors' assets to fund both their lending operations and their trading subsidiary, Alameda, in a clear case of corporate fraud.

In each of these cases, it's important to understand how private credit, with its limited regulation and transparency, contributed to the eventual collapse of various trading firms and businesses, with private credit being used as an unregulated means of accessing leveraged loans, with little concern for credit quality. In the case of FTX, it goes so far as corporate fraud.

Following the collapse of these companies, other private investment firms have been purchasing up the crypto industry's distressed debts, with around $250M in FTX claims being gobbled up to date. In these cases, private companies purchase claims to debtors assets at a fraction of their nominal value.

It's important to note however that none of these companies do not represent DeFi itself, rather, they are examples of traditional corporations failing within the crypto space.

When these companies failed, many of the DeFi protocols they took loans from did not suffer any losses. This is because all DeFi loans were fully collateralized and agreements were executed on-chain, making fraud or centralized mismanagement impossible.

RWA Investment

Other platforms are trying to put their own crypto 'spin' on traditional forms of private credit investment, particularly in the rapidly growing RWA investment space. Several platforms, including Goldfinch, Maple Finance, Centrifuge, and more, are all focused on delivering private credit investment opportunities to everyday investors.

Whilst these products often feature high returns, there have also been some notable defaults. For example, both Goldfinch and Maple Finance have experienced counterparty defaults, highlighting the risks involved.

Indeed, with limited transparency and regulations governing the industry, these new crypto-native forms of private credit may carry significant risks for unsophisticated investors, despite the attractive interest rates on offer.

What are the advantages of Crypto for Direct Lending and Private Credit?

Despite the concerns over the role of the private credit industry within crypto, the use of blockchain technology, DeFi, and other distributed ledger technologies can offer several advantages for direct lending, and indeed the private credit industry as a whole.

It is important to note that these advantages only relate to the technology, not the industry as a whole. For example, a lot of crypto-native companies discussed do not use DeFi technology directly.

#1: Improved efficiency and speed of transactions

Smart contracts can automate many of the manual processes involved in traditional private credit transactions, such as loan origination, servicing, and collections. This can significantly reduce the time and cost of executing private credit deals.

#2: Increased transparency and security

The use of blockchain technology in DeFi can provide a high degree of transparency and security for tokenized private credit transactions and loans. All transactions are recorded on the blockchain, which creates an immutable record of the transaction history. Furthermore, smart contracts offer the potential to ensure that loan agreements are self-executing on-chain, reducing the risks of fraud and other centralized points of failure.

#3: Greater accessibility to capital

Crypto and DeFi can help to connect borrowers and lenders from all over the world, which can increase access to capital for borrowers and expand the pool of potential investors for lenders. This can be particularly beneficial for borrowers in developing countries or other areas with limited access to traditional banking services.

Equality, the increased liquidity associated with fractionalized loans can help unlock increased trading liquidity for various private credit investments on secondary markets.

#4: Increased innovation and product development

Smart contracts can be leveraged to create entirely new and innovative private credit products and services. The kinds of over-collateralized loans seen in DeFi today could just represent the tip of the iceberg.

#5: Improved risk management and data privacy

Crypto can provide new tools and data for private credit lenders to manage and monitor risk. For example, borrower performance can be anonymized using technology like zk proofs, whilst still allowing for permission credit risk assessment based on immutable on-chain data sets.

What are the challenges to private credit in crypto?

Having said all that, there are many challenges to private credit in DeFi and crypto, with many of the advantages discussed remaining, for the time being, largely theoretical. Notable challenges include smart contract risks, legal and regulatory obstacles, oracle risks, last-mile problems, and more.

For example, to access a loan in DeFi, a lender needs to have sufficient spare capital, specifically crypto assets, to completely collateralize their debt obligations. For most small and medium enterprises, this isn't practical. Therefore, we can expect the private credit industry to continue meeting the demand for alternative sources of financing.

However, given the ease of tokenizing traditional financial assets, such as bonds and other products, the scope for crypto to impact the private credit industry is disproportionately large when compared to other industries.

How can I access Private Credit Opportunities in Crypto?

Whilst both government bonds and corporate bonds are an accessible asset class for most individual investors, private credit has traditionally been off-limits. Now, crypto is promising to change the dynamic, at least slightly.

Most traditional forms of private credit investment, in crypto as well as traditional finance, are network-driven and require a significant degree of financial knowledge, risk appetite, and experience.

Moreover, financial regulations mean that most of these opportunities are restricted to high net-worth individuals and other private institutions.

Despite this, there are several accessible ways for users to access new private credit opportunities in crypto today. You can also read this article on how to invest in DeFi here.