The current state of DeFi loans

Since 2017, under-collateralized loans have been the holy grail that DeFi is difficult to achieve.

The current status of DeFi loans


Since 2017, under-collateralized loans have been the holy grail that DeFi is difficult to achieve. Currently, through platforms such as Maker, Compound, and Aave, most of DeFi provides relatively circular use cases in the form of over-collateralization. This is mainly because the only ones willing to issue 1.5-3 times leverage are traders who want to use leverage in the cryptocurrency market. Under-collateralized loans can enable decentralized credit markets to facilitate a wider range of use cases and may make DeFi mainstream.

This is why some participants have been trying to launch this market since 2017/18. However, historically, the key challenge has been to find an appropriate method to assess and allocate the creditworthiness of borrowers and ensure the safety of lenders’ deposits. In 2020/21, the trend of insufficient mortgage loans has regained its momentum and brought some innovative methods to solve the problem of decentralization of credit evaluation. In this article, we will delve into each solution and evaluate the use cases, benefits, and risks of each solution. In general, this field is still in its infancy, and no matter which project/method can ultimately work, under-collateralized loans may lead the next wave of DeFi adoption and growth.

The current situation of insufficient mortgage loans can be divided into eight key parts:

  • Flash loan
  • Third-party risk assessment
  • Encrypted local credit score
  • Off-chain credit points
  • Personal network boot
  • Real-world asset loans
  • NFT as collateral
  • Digital asset loan

1. Flash loan

The current status of DeFi loans

Use cases : arbitrage, collateral swaps, liquidation

Advantages : almost instant repayment, no risk of default

Challenge : Cannot be used for most traditional use cases, such as personal loans.

A flash loan is an unsecured loan. Borrowing and repayment must occur in the same transaction at the same time. Both must be complete so that one can be processed. This fact ensures that the risk of default is essentially zero. This structure is especially useful for arbitrageurs who want to take advantage of the opportunity between two DEXs and avoid price fluctuations while using leverage. This is why more than 80% of flash loans over US$3 billion are limited to arbitrage. In general, flash loan is an innovative product, but it is unlikely to be used except for arbitrage and collateral swaps.

2. Third party risk default

The current status of DeFi loans

Use cases : personal loans, microfinance, decentralized prime brokerage

Advantages : distributed counterparty risk; combining financial incentives with credit assessors

Challenge : Establish a network of professional risk assessors with sufficient data + tools to make appropriate credit decisions

Third-party risk assessment has always been a hot project for venture capital in 2021. Both Maple Finance and Goldfinch have raised meaningful financing from well-known funds. This model introduces a third group besides lenders and debiters to perform the role of credit evaluation. In exchange, the group must pledge some of its liquidity, and once a loan they approved defaults, this liquidity will first be greatly reduced. This establishes a reasonable incentive structure, makes insufficient collateralization possible, and paves the way for an on-chain credit scoring system.

The main challenge of this structure is to use the appropriate level of borrower data to guide a network of capable credit assessors. This is more challenging for retail institutions such as Goldfinch compared with major agency-oriented brokerage companies such as Maple. However, if a platform can gather a group of competent evaluators and smooth the process of providing borrowers’ data, this may be a viable model.

3. Encrypted native credit score

The current status of DeFi loans

Use cases : personal loans, microfinance, etc.

Advantages : data persistence and immutability; cross-platform availability

Challenge : At present, most users have insufficient data on the chain; the ability of users to switch wallets by default

Through the use of various historical activities on the chain to guide the identity on the chain, including historical loan repayment, liquidity mining, transaction activities, governance participation, etc. This can be valuable because the data will be continuously and automatically updated. In addition, the data can be used across multiple platforms based on user consent. Although on-chain identity may be inevitable, the initial stage we are currently in is challenged by unlimited virtual identity capabilities. If one party breaches the contract, it will switch wallets. In this regard, the most feasible solution may be some form of ZK proof, allowing customers to safely share their real-world ID on the chain and bind it to a single wallet anonymously. A platform that passes this barrier will eventually facilitate the movement of large amounts of data, making it relatively valuable.

4. Off-chain credit points

The current status of DeFi loans

Use cases : personal loans, microfinance, etc.

Advantages : sufficient data; connected to a fixed logo

Challenge : Non-encrypted native; reliance on TradFi infrastructure

This solution helps to collateralize under-collateralized loans by importing off-chain credit data, and solves the guiding challenges faced by encrypted native identity. This is an appropriate strategy in the short term, but needs to transition over time to the use of encrypted native data on the chain in order to be inserted into any decentralized stack.

5. Personal network boot

The current status of DeFi loans

Use cases : personal loans, microfinance, etc.

Advantages : low default rate due to organic network effects

Challenge : If other parameters are not used, it is difficult to expand; the user’s ability to switch wallets

In this use case, the borrower must be directly approved by the loan pool member. By inviting lending, the platform grows through organic network effects, introducing an element of off-chain trust. This is a smart way to provide loans with insufficient mortgages on their own without relying on potentially limited data. The key challenge of this approach is to expand the network without integrating additional data points, because data collection based on these repayments alone takes time to be statistically significant. In general, this is a viable strategy that can be appropriately converted over time to effectively scale.

6. Real-world asset loans

The current status of DeFi loans

Use case : Mortgage loans and other physical asset loans

Advantages : partly mortgaged by real-world assets

Challenge : Insufficient potential liquidity of tangible assets, depending on market conditions

Real-world assets are represented on the chain by NFT, which provides collateral for the other part of the loan. This looks very much like a traditional mortgage, except that loan financing is decentralized. The only challenge facing this approach is insufficient liquidity of assets, even for concentrated loans. Although this market is still in its early stages, the outlook is very optimistic because it can eliminate a lot of red tape and bureaucracy, which is the characteristic of the TradFi version of real-world asset loans.

7. NFT as collateral

The current status of DeFi loans

Use cases : personal loans, microfinance, etc.

Advantages : Able to use NFT as collateral

Challenge : Insufficient liquidity of assets

NFT-backed loans are an interesting concept that can become a niche part of the broader space for under-collateralized loans. In the long run, some NFTs may reach a Jackson pollock-like status, thus making their market relatively liquid. Since NFTs are cryptographically native, if they are liquid, it is easy to express them on the chain and use them to resolve default values. However, the reason this market may still be a niche market in under-collateralized loans is that most NFTs may fall out of favor and lose market liquidity, making them a poor mortgage option.

8. Digital Asset Loan

The current status of DeFi loans

Use case : leveraged trading

Advantage : control trading assets

Challenge : limited scale

This use case is similar to Aave, Compound, etc. The difference is that Lendfi itself maintains the custody of the purchased assets in the smart contract until the loan is repaid. Therefore, if a transaction of borrowed assets is detrimental to the borrower, the contract will liquidate the position and make up for the loss before returning the remaining capital. This may be another relatively niche use case.

in conclusion

In general, it is clear that although it is just getting started, the area of ​​insufficient mortgage loans is booming. As the field continues to experience the pain of growth, we believe this may be where we see the next wave of DeFi innovation. Eventually, projects that can adapt and survive may build barriers for the mainstream adoption of DeFi.

Posted by:CoinYuppie,Reprinted with attribution to:
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

Like (0)
Donate Buy me a coffee Buy me a coffee
Previous 2021-07-06 06:46
Next 2021-07-06 06:52

Related articles