The Coming Crisis in the Decentralized Lending Market

Credit has become the fastest growing decentralized finance (DeFi) sector in recent years. Now, this segment represents almost half of the total transaction volume of the DeFi market, or, to be more precise, around $40 billion, according to Statista.

Most experts agree that’s not the limit, given the rapidly growing demand for loans and the huge pool of potential lenders. The decentralized lending market can easily grow exponentially due to its advantages over traditional lending.

Image source: Statista

The main advantage is the drastic increase in the number of potential creditors. DeFi’s open architecture allows any cryptocurrency user to become a lender if they are willing to take the risk. At the same time, in a decentralized system, credit risks are lower, because information on the financial situation of borrowers is more transparent than in the traditional financial system.

Savings for borrowers

The decentralized market offers significant savings to borrowers, since they can meet lenders without intermediaries. Additionally, borrowers can interact with multiple pools of lenders simultaneously, forcing them to curb their appetites.

Giving and receiving cryptocurrency loans has become extremely popular since the advent of the Aave and Compound credit protocols, which allow users to offer crypto-assets for interest or use their value as collateral to borrow money. other assets. Analysts note, however, that these platforms operate more like a pawnbroker than a bank, forcing borrowers to over-collateralize their loans. In other words, when one takes out a loan, its average guarantee is 120% of the principal.

The inefficiency of this system is obvious: depositing $120 of collateral to obtain a loan of $100 can only be justified for a very limited number of trading transactions, such as short-term speculation or leveraged trading. However, this particular collateral system is the most popular in DeFi today, as the traditional mechanism for assessing the reliability of borrowers (a credit score) is not applicable in decentralized finance. The reason is simple: almost all transactions are made anonymously, which means that it is simply impossible to establish a credit history for a specific borrower.

Overcollateralization as the main obstacle to decentralized lending

Every day it becomes more evident that the system of excessive collateral on loans is becoming the main obstacle to the development of both decentralized lending and the entire DeFi segment. And the crisis is just around the corner: according to a recent report by Messari, in the third quarter of this year, liquidity providers on Compound received the lowest interest rates on their contributions since the launch of the platform.

Interest rates are falling mainly due to the influx of new lenders hoping to make a profit. And even if the increase in the volume of loans remains higher than the growth in the amount of deposits (57% against 48% over the quarter), this gap is rapidly closing and will soon disappear. In other words, the supply of loans will exceed the demand. This can lead to a sharp drop in lenders’ income and a collapse of the decentralized lending market.

According to Messari, due to lower loan interest rates, lender revenue in the third quarter of 2021 alone fell 19% (from $96 million to $78 million). To reverse this trend, the DeFi industry must learn to lend with little collateral or, ideally, none at all. It will be a milestone in the evolution of the industry, opening up opportunities for decentralized business lending and rescuing DeFi from stagnation.

Looming credit stagnation

There are no easy solutions here. That is why many companies are fighting the impending stagnation by creating more attractive conditions for customers in terms of collateral volume and loan rates. The most radical example is the Liquity project, launched in April, which offers interest-free loans where borrowers must maintain a minimum collateral rate of “just” 110%. Unfortunately, the benefits that this innovation promises to creditors are not yet clear.

Other projects focus on protecting clients from the volatility inherent in the cryptocurrency market in general and the cryptocurrency lending market in particular. As a result, fixed rate loans are now all the rage. In June, Compound Labs announced a product called Compound Treasury, which guarantees deposits at a fixed interest rate of 4% per annum. Compound expects the Treasury to generate more dollar-denominated liquidity, which could make lending rates more attractive to borrowers.

Yet these half-measures can only delay the crisis in the decentralized loan market. It is also becoming clear that DeFi cannot reach its next level of development without the advent of decentralized business lending. The problem is that businesses will never take out loans with full collateral.

The future belongs to bonds

How can we solve the problem of loans without using all the guarantees? Only a few projects accepted this challenge. Compound Labs’ main competitor, the Aave platform, is developing a limited form of unsecured lending through a loan delegation mechanism. This model shifts the responsibility of backing the collateral to the debt insurer, who will assume responsibility for debt collection, and the end customer will receive a loan with partial collateral or no collateral at all. Including the debt insurer in the loan process, however, will make loans more expensive for the borrower and reduce the profit for the lender.

A similar mechanism was launched this year by Cream Finance in the form of Iron Bank’s loan service. It provides under-secured loans to a limited number of agents, the reliability of which has been previously assessed by Cream Finance’s experts. That being said, it’s still unclear how Cream plans to reimburse liquidity providers if an approved borrower fails to return the money.

DeBond Program

Another new project — DeBond — has managed build a scheme that closely resembles established traditional market practices. The Company provides debt financing through bonds.

This model requires a potential borrower to pledge their digital assets to a smart contract and define loan parameters, including the term, amount, interest rate, time, and amount of each loan payment. Moreover, the user can choose all these parameters individually, according to his own needs and abilities. This smart contract is a complete analogy to a traditional bond, as the borrower can choose its type – fixed income or floating rate. A formalized smart contract is placed on an electronic auction site, where the lender can purchase such a bond if the terms offered are attractive. As a result, the issuer receives a loan and the lender receives a pledge and his money, secured by a smart contract.

But that’s not all: the new EIP-3475 algorithm used by DeBond allows the lender to issue derivatives on outstanding loans, bundling them into new bonds with different combinations of risk and return. These derivatives can be traded on the secondary market, using DeBond’s platform. Thus, their credit risk is shared between the liquidity providers. This is a major advantage for the lender over existing DeFi lending protocols. For the borrower, the main advantage is that the collateral will not need to be liquidated if its value falls below the established threshold of 110-150%.

Bond loans

DeBond’s attention to the mechanism of bond lending is well justified, since bonds are the primary vehicle for corporate lending today. At the end of 2020, dollar-denominated bonds totaled nearly $21 trillion, exceeding 132.5% of nominal U.S. GDP. To draw an analogy, we can apply the same ratio to the total DeFi market capitalization, which is just over $52 billion. This implies that the bond market volume in this segment should be $69 billion.

If DeFi succeeds in launching instruments similar to traditional bonds, decentralized finance can become an important market for corporate debt and an influential segment of the global financial market. After all, rightly like Cream Finance Noted in his presentation, the $70 billion market for direct bank lending is “a paltry sum compared to the size of all US corporate debt which, by the end of 2020, topped $10 trillion of dollars”.

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About Pamela Boon

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