Can blockchain DeFi loans fill the financing gap of small businesses?

In the real world, we tend to define borrowed money by purpose. Loans start with the label—family, university, business—and represent an investment in a tangible goal.

We want our houses to increase in value; our degrees to promote high-paying jobs; and our business needs to expand. The logic is simple: when we need to make up for shortcomings, we will borrow money, hoping that this money will pave the way for our future success.

However, this reason is flat on the blockchain. Lending agreements are not that close to solving real-world problems—in fact, most people involved in DeFi lending never take the borrowed money offline, let alone apply it to real-world expenses.

Sometimes loans in the market are not as people say, they are more approachable to traditional borrowers. 

“DeFi [loans] are not for the faint-hearted,” Reuters’ Tom Wilson wrote in August last year. “Borrowers are usually traders. They take loans in areas such as Ethereum, and then use these tokens to trade with other cryptocurrencies on various exchanges. Then their goal is to repay the loan and collect their profits. Like a short seller in the stock market.” 

For these borrowers, loans are usually a means of generating income, rather than a practical method of solving problems or goals.

“I trade for fun,” crypto enthusiast Antoine Mouran told Wilson in an interview. Mouran, a college student in Lausanne, borrowed USD Coin from Aave and used these funds to trade Lend coins. “My portfolio is a few thousand dollars.”

But the question is-will the only people who can benefit from blockchain-based loans be investors like Mouran?

Can DeFi-based loans also open up new opportunities for traditional borrowers who want to use the borrowed money to solve real-world problems? 

This is a question worth asking more than ever. After the global pandemic, countless small business owners are faced with a long-term skepticism: traditional financial institutions will not always be there to catch them when they fall. According to the Biz2Credit Small Business Loan Index, big banks only approved 13.2% of the financing applications they received in January 2021-a double-digit decrease compared to the same period in 2020. 

Of course, even before the pandemic, it was not easy to find financial support. Last year, the Federal Reserve’s small business credit survey found that only 51% of small business owners received all the funds they requested in 2019, and 20% of small business owners chose to refuse some or all financing due to high interest rates. 

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Obviously, the traditional financial products provided by centralized institutions no longer meet the needs of today’s business owners. They need small loans that can be obtained flexibly and quickly without the high interest rates or low approval rates that centralized banking entities often bring. 

DeFi enables developers to create such complex, customizable, and accessible microfinance products. But not just convenience, the shift to blockchain lending will democratize lending and give more agency power to consumers who traditionally have no say in the design or accessibility of their loan products. 

This is an intuitive solution to a seemingly indisputable stumbling block: overcollateralization. 

The high cost of anonymous borrowing

Even among blockchain enthusiasts, using DeFi loans as an important financing solution for small business owners with cash shortages may not trigger an overwhelmingly positive response.

Anonymity has a price-in the case of DeFi loans, the price is over-collateralization. When a person applies for a traditional loan, their banker will conduct a credit check and income verification to confirm that the person is capable of repaying the borrowed amount.

On the blockchain, user anonymity will naturally block such comments and force lenders to find another way to protect their investment. 

The solution is usually overcollateralization: the borrower puts down mortgage assets that exceed the total value of the loan. This kind of participation capital can be said to be astonishingly high. For example, those who wish to obtain a Dai loan on MakerDAO need to mortgage at least 150%. 

In other words, many people choose to let go, or even more, to avoid triggering liquidation penalties-that is, the fees incurred when the price of Ethereum drops, keeping investors’ collateral value below the mandatory threshold of 150%.

According to the statistics of DeFi Rate, the average mortgage rate of all platforms is as high as 348%. 

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Let us put it in the context of a theoretical small business owner. If they want to spend $2,000 to cover the wage gap and follow the average mortgage rate of DeFi Rate, they need to spend $6,960 to get a loan.

Even if they have the money, they seem unlikely to justify locking up these funds as collateral. Unlike players like Mulan, they are not seeking financial support, but a springboard for investment. Most companies do not have “thousands” as collateral. 

As NPR’s David Arnold explained in an article last year:

“Many small businesses operate a bit like people who live on their salary, without much savings.”

This is true. According to research conducted by the JPMorgan Chase Institute, small businesses usually have only one month of cash on hand to maintain operations. These are not consumers who can withstand over-collateralization. In order to take advantage of DeFi loans, lenders first need to avoid the need for overcollateralization.  

Eliminate the need for overcollateralization

At first glance, it seems impossible to eliminate overcollateralization. After all, the traditional model of guarantor support-lowering or giving up collateral based on personal credit-runs counter to DeFi’s philosophy of anonymity. If lenders start to request personal financial information or obtain personal credit reports from central agencies, they will effectively break the core principle of blockchain-based finance: privacy. 

However, it is a way to build credibility while keeping the borrower anonymous. The answer lies in the creation of an identity layer protocol that whitelists the user’s unified wallet address and evaluates their credit behavior only through this address and any other whitelisted addresses that the user chooses to include.

The agreement will only collect financial information necessary to establish a certain reputation, and will not collect any sensitive personal information that may be detrimental to the borrower in the event of a disagreement or default. 

As commented: “There is no doubt that the blockchain concept has the ability to prevent duplication and divergence on the chain, and has a highly committed identity. On a distributed ledger, everyone can believe that the content of the ledger is there, and it is it. The only version of .” 

However, this solution may not be sufficient to completely exempt the high mortgage requirements. To this end, the lender and the borrower may need to establish a credit entrustment agreement through a smart contract.

These contracts will establish very important terms and conditions related to interest rates and terms as a public law, thereby providing a constant reference point.

In short, these features can provide sufficient guarantees for lenders to reduce their mortgage requirements to a level that is more acceptable to business owners. However, concerned borrowers can further reduce their personal risk burden by participating in community-based microfinance. Under this arrangement, the lender will provide liquidity to pool and serve dozens of small “micro loans.”

In this community lending ecosystem, risk is shared, so no lender alone bears the risk. 

Low mortgage, blockchain-driven small loans are both possible and worth pursuing. Under this arrangement, business owners with tight funds can not only obtain much-needed funds, but also have a say in the design of their financial products-this kind of say is rarely allowed, if at all, in the central banking system. As far as lenders are concerned, they will have the opportunity to profit from these loans and inject much-needed innovations into the lending ecosystem that has long been dominated by centralized financial giants. 

Is blockchain-based microfinance a dream? Today, yes-but tomorrow, it is likely to provide financial support for real-world aspirations.

Original Author | Ankit Gore, CEO of EasyFi

Compilation | Baize Research Institute

 

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/can-blockchain-defi-loans-fill-the-financing-gap-of-small-businesses/
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