Specialist crypto ETP provider ETC Group has issued a warning to investors regarding the emergence of low-cost crypto products that offset their operating costs by engaging in potentially risky lending practices.

Bradley Duke, Founder and co-CEO of ETC Group.

The firm notes that, over the past two years, crypto ETPs have become extremely popular in Europe, drawing in billions of dollars from retail and institutional investors and driving many asset managers to launch their own digital asset investment products.

As of February 2022, there were 73 crypto ETPs in Europe, comprising $7 billion in assets under management which was more than 50% of the global AUM total.

With intensifying competition and a dramatic fall in crypto prices this year, ETP providers have begun offering products with significantly lower management fees in an attempt to attract investors.

ETC Group notes, however, that many of these newer, lower-cost crypto ETPs are inherently riskier than existing products as their underlying digital assets are being lent out instead of being held unencumbered in safe custody. According to ETC Group, these lending practices are often uncollateralized with little transparency about the actual risks being taken and who pockets the proceeds.

Bradley Duke, Founder and co-CEO of ETC Group, commented: “At a time when some high-profile crypto businesses with exposure to crypto lending have failed, it’s irresponsible for some crypto ETP providers to promise lower fees to lure investors without being transparent about the increased intrinsic risk of their products.

“What’s more, to lend out the assets supposedly backing the ETPs without full transparency, and without even sharing the profits of this activity with the investors who are actually bearing the risk, is dubious practice and bad for the sector.

“We’ve released this latest research to better inform investors about the inherent risk in some products based on how they are structured. ETC Group remains focused on the highest quality and structure of crypto ETPs with investor safety front and centre of product design.”

ETC Group offers 14 directly backed crypto ETPs with each product being fully restricted from lending its underlying assets. The suite includes the $400 million ETC Group Physical Bitcoin ETP, Europe’s largest physical bitcoin ETP, which comes with an expense ratio of 2.00%.

In comparison, rival digital assets specialist 21Shares last month unveiled the 21Shares Bitcoin Core ETP (CBTC SW), the world’s cheapest directly backed bitcoin ETP with an expense ratio of just 0.21%. The ETP’s low price tag is achieved by participating in collateralized lending agreements which serve to cover operational costs. According to 21Shares, loans are executed through institutional-grade partners, are overcollateralized by at least 115% (collateral will typically be bitcoin, ether, or USD Coin), and are monitored daily to protect the interest of the ETP’s shareholders.

In a blog post on its website, ETC Group has launched a fierce criticism of this new product, stating that “It is hard to understand how a BTC loan could be collateralized by 115% BTC and make commercial sense, or indeed with ETH or USD Coin which are consistently more expensive to borrow. Without a clearly defined collateral schedule baked into final terms, such products should make investors wary.”

ETC Group further notes that in typical lending practices, the collateral used to back loans usually comprises assets uncorrelated to the asset being loaned.

Finally, the firm writes that even over-collateralized loans may contain a notable risk of borrower default. One of the latest high-profile examples is Singapore-based hedge fund Three Arrows Capital which filed for Chapter 15 bankruptcy in the US, having defaulted on a $670m loan from Canadian broker Voyager Digital.

According to ETC Group, the current risk of defaults is significant as cryptocurrency markets are undergoing a credit crisis. The firm notes that rehypothecation (the re-use of collateral made in one agreement as the basis for new, separate loans with other entities) in crypto markets is rife, especially amongst lending institutions, adding enormous additional risk to relevant products at times of market stress.

ETC Group writes: “As it is not clear the extent to which businesses that do engage in lending are exposed to other risky loans or troubled companies, this makes ETPs that are deliberately built around lending out crypto assets especially high-risk.”