Has Bitcoin’s crash revealed flaws in Wall Street’s bond experiment?

A bond offering tied to bitcoin loans has run into problems after a sharp decline in crypto markets forced lenders to sell off a significant portion of the backing assets.

Jefferies bankers have spent recent months reaching out to major investors about a $188 million bond backed by thousands of individual loans from crypto lending company Ledn. These borrowers pledged crypto to secure one-year loans, with the bond proceeds intended to fuel more lending activity.

What triggered the forced liquidations?

Unexpected issues arose from the recent bitcoin meltdown. An insider with knowledge of the transaction said that prices dropped 27% from their mid-January peak, causing automatic sell-offs on about 25% of the loans meant to underpin the bond.

These securities represent part of a broader comeback for asset-backed bonds, financial instruments that gained notoriety during the 2008 crisis. Today, big insurance companies and investment funds are turning to them as they hunt for better returns than traditional bonds provide. The Ledn bonds are projected to deliver returns 3 to 6 percentage points higher than standard benchmark rates, data from CreditFlow shows.

Jefferies has been expanding its presence on Wall Street by offering more varieties of asset-backed securities, including some newer structures that present challenges for risk evaluation. The firm has also pushed into cryptocurrency deal-making, notably guiding trading platform NinjaTrade through its $1.5 billion transaction with crypto exchange Kraken last year.

When Jefferies first approached potential buyers, the plan called for backing the bonds with $199 million in bitcoin loans plus $1 million in cash. Those numbers have shifted dramatically. The new mix includes about $150 million in loans alongside $50 million in cash, the source said.

Despite these changes, the transaction remains scheduled to complete on Feb. 18, S&P Global Rating confirmed. The rating agency has already evaluated and rated the bonds. Ledn now faces the task of issuing fresh loans using money from the liquidations to produce the interest payments bondholders expect.

Adam Reeds, who serves as Ledn’s chief executive, defended the liquidation process. “The liquidation and replenishment mechanics are designed to protect noteholders’ capital, not expose it,” Reeds stated. “Ledn has operated through nearly a decade of volatility without principal losses on liquidations.”

The situation highlights the difficulties in building a functioning market for securities backed by volatile cryptocurrency assets. Issuers of asset-backed securities rarely liquidate such a large share of supporting loans, particularly before actually selling bonds to investors.

“However, for Ledn, this methodology is limited by both a short performance history and a lack of borrower credit data,” S&P noted in a Feb. 9 analysis.

How the lending system operates

Many customers take their loan money and purchase additional bitcoin. These “balloon” loans carry steep interest rates, about 11.8% on average, but require no payments until the full amount comes due.

When bitcoin prices drop and push the loan above 70% of the collateral’s worth, Ledn requires borrowers to add more bitcoin. If that ratio hits 80%, the company automatically sells the bitcoin to cover the loan and returns any remaining funds to the borrower.

This system has functioned effectively so far. Over seven years, Ledn has liquidated 7,493 loans with a maximum loan-to-value reaching 85%, and the company has recorded zero losses, S&P reported. Roughly 20% of borrowers whose loans back these bonds chose to park extra collateral that automatically supplements their loans when bitcoin prices slide.

Some borrowers added collateral while others paid off their loans ahead of schedule, which helped them dodge liquidation and retain their cryptocurrency.

The real danger emerges if bitcoin experiences an even steeper decline that overwhelms market capacity. S&P’s analysis identified a potential conflict since Ledn routinely converts maturing loans into new ones, letting unpaid interest accumulate and possibly raising default risks. Should 79% of loans fail, bondholders could see losses approaching one-third of their investment, the rating firm warned.

Ledn has previously secured funding through equity sales, including a November strategic investment from Tether.

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