The Evolutionary Path of Blockchain Lending: From Crypto Pawnshop to Credit Agency

An article to understand the path of the DeFi lending protocol.

Today, the main form of DeFi lending is over-collateralized lending, where to get a $100 DAI, you need to take $150 worth of ETH as collateral.

There are a few project parties trying to launch low-collateralized lending operations, but the winner has yet to emerge, and this article will cover the various existing and yet-to-be-launched crypto lending protocols, as well as the next steps for blockchain credit.

Let’s get started.

Long story short.

Today’s mainstream DeFi lending protocols are effectively the equivalent of pawnshops of the past, with the collateral universe eventually incorporating NFTs and tokenized real-world assets as more assets are added to the chain.

The main drawback here is constrained liquidity and poor price discovery. Low-collateral DeFi lending will first be geared towards off-chain legal entities, and this is already gaining some momentum. For individuals to access low-collateral crypto loans, two things are necessary: a digital identity and a decentralized reputation.

The Evolutionary Path of Blockchain Lending: From Crypto Pawnshop to Credit Agency

INTRODUCTION
The main reason that the vast majority of loans in the DeFi space today require overcollateralization is that parties use semi-anonymous addresses, where lenders do not know the identity of the borrower and his or her reputation, and vice versa.

In the absence of any credit score for the borrower, the lender can only extend credit for an amount less than the value of the collateral. This is usually described by the loan-to-value (LTV) ratio, which must be less than 100%.

LTV = Loan/Collateral Value * 100%

In the example above, where a $100 DAI is used as a loan and a $150 ETH is used as collateral, the LTV value would equal 67%. Currently, the average LTV of mainstream DeFi lending agreements is between 50% and 80%, with the ratio value depending on the quality of the collateral assets.

This model is no different from the traditional pawnshop practices of centuries past; in fact, pawnshops are one of the oldest financial institutions, which can be traced back to 5th century AD China.

The Evolutionary Path of Blockchain Lending: From Crypto Pawnshop to Credit Agency

Early Chinese pawnshops

With the advancement of financial literacy and the emergence of various intermediaries, pawnshops have given way to credit. The main difference between the pawnshop business model and credit is that in the latter case, the lender is willing to provide a loan in excess of the value of the collateral provided (i.e. when the LTV ratio is greater than 100%).

To do so, the lender will conduct its own due diligence based on available information and assess the risk of default for a given borrower. However, this exercise requires (a) a non-transferable identity and (b) more or less reliable data about the credibility of that identity.

DeFi’s current state is that of a crypto-pawnshop, through which autonomous protocols can facilitate over-collateralized lending, thereby replicating the script of the Dark Ages.

The Evolutionary Path of Blockchain Lending: From Crypto Pawnshop to Credit Agency

But the industry will move forward. Here’s a look at the current state of affairs and a prediction of what the future will look like.

Crypto Pawnshops
As mentioned above, pawnshops issue loans based on a loan-to-value ratio of less than 100%. The two main business model parameters for pawnshops are.

1, LTV

  1. Quality of collateral

The loan-to-value take (LTV) depends on the quality of the collateral.

In the first generation of crypto pawnshops, the creditworthiness of the borrower is only reflected in the quality and quantity of the collateral. In real life, however, there are many other factors to consider in assessing the creditworthiness of a loan applicant.

As mentioned earlier, this is not the case with DeFi today due to the pseudo-anonymous nature of the transaction.

Good collateral
Good collateral has several characteristics, and according to the European Central Bank (ECB) framework, good collateral is liquid and secure (as further defined in the study above).

Not surprisingly, BTC and ETH are the most common types of collateral used in DeFi lending agreements. In addition to volatility, they seem to meet the above criteria. Even volatility can be mitigated by instant liquidity enabled by the stable liquidity of a decentralized exchange (DEX).

Non-homogenized tokens (NFT) as collateral
The next frontier for DeFi pawnshops is the less liquid crypto asset that is currently difficult to value, the non-homogenized token (NFT) space.

NFTs have experienced rapid growth in 2021, and with the proliferation of NFT holders, several teams have begun to establish lending agreements against NFT collateral.

1、NFTfi

2、Stater (beta stage)

3, PawnFi (only a twitter announcement, no product yet)

The problem with NFT is the low liquidity and opaque valuation due to the lack of a fixed feed price. When prices fall, it is difficult to liquidate collateral immediately. Given the secondary nature of the market, it is equally challenging to know when prices are actually falling.

One way to address the lack of liquidity and price discovery is to tokenize NFT back to ERC20 and trade it on DEX. This is what NFTX and NFT20, for example, are doing, and tokenization helps with price discovery and liquidity.

There are many different types of NFTs and the question is which one to use as collateral for DeFi lending in the first place.

Based on the quality of collateral discussed in detail in the ECB document, the most liquid and easily valued NFTs can then be used as collateral.

In this case, tokenized NFTs would be used first as collateral due to liquidity.

We believe that NFT assets from games and the metaverse (metaverse) will be next. First, game assets usually have specific digital utility (more advanced skins, stronger weapons, etc.), while the value of digital collectibles is in the eye of the beholder.

Second, assets from virtual games are also more likely to have continuous price supply and deeper liquidity in their respective ecosystems. However, to use gaming assets as collateral, the gaming ecosystem itself should not be closed off, which seems to be the case at the moment.

Real World Assets
After traditional crypto assets and NFTs, the next big basket of collateral is tokenized real-world assets (RWAs), with fiat currencies, real estate, gold, securities (stocks and bonds), invoices, tickets, etc. all available as collateral for blockchain lending. For example, fiat currencies and real estate have been tested as collateral for DeFi lending agreements (e.g., USDC in MakerDAO and RealT tokens in Aave).

In addition to the standard quality of sound collateral, tokenized RWAs are subject to specific risks arising from the tokenization process, such as

Is there an issuer, such as Circle, the company behind USDC?

How transparent is the issuing entity?

Are the reserve assets auditable?

Where are the actual assets held in real life (banks, custodians, etc.)?

Do these assets require any specific storage or maintenance procedures (e.g., gold)?

If the issuing entity is a country, what are the political risks?

Is there a robust legal enforcement framework to rely on in the event of a borrower default?

In addition, certain RWAs may be subject to special rules, such as KYC/AML and negotiability requirements. This will affect the scoring of these assets as collateral and may even prevent these assets from being traded globally.

Crypto pawnshops will move away from overcollateralization types to more capital efficient lending practices. And for this to happen, two fundamentals must emerge.

Digital identity.

Digital reputation.

We’ll discuss this in more depth below.

Encrypted credit institutions
The transition from a pawnshop business model to credit (low-collateral lending) requires

A non-transferable identity of the borrower, and

Some information about their creditworthiness (credit score)

The identity should not be transferable, otherwise the lender will never be able to determine who the identity belongs to and whether the credit score actually belongs to that person.

Corporate DeFi Lending
From a legal perspective, there are two types of entities in this world: natural persons (individuals) and legal entities (corporations). The former have been around for a long time, while the latter emerged relatively late. One of the earliest legal entities was the Dutch East India Company (VOC), chartered in 1602.

In this sense, a legal entity is 1/750th of the age of Homo sapiens, which is too young!

However, in contrast to individuals, corporations were the first entities to receive collateralized DeFi loans, and the projects that were constructed in this regard were

TrueFi

Maple Finance

Goldfinch

Centrifuge*

Note: Centrifuge positions itself as a platform where users bring traditional financial assets into DeFi, but it also offers credit against tokenized assets.

These agreements look more like traditional banks in that they originate borrowers, assess their creditworthiness, and enter into legally binding loan agreements.

The main difference between these agreements and conventional banks is the source of funding. Whereas banks take funding from deposits, these agreements take funding from a pool of anonymous (TrueFi) or non-anonymous (Centrifuge) crypto-native investors.

The borrowers of these agreements are usually well-known names in the crypto industry, such as crypto trading pools, miners, crypto funds, etc. This can act as a proxy for credit scoring and ensure consistency of value between borrowers and lenders.

Whether DeFi corporate lending will meet measurable goals depends on whether these agreements can meet demand and supply.

From a demand-side perspective, the question is whether these platforms will be able to originate enough corporate borrowers who are willing to obtain a cryptocurrency-designated loan at a given interest rate.

Potential crypto-DeFi borrowers are likely to be companies (or DAOs) that are unable to obtain loans in the traditional financial markets (banks, bonds, etc. lines of credit). In addition, crypto DeFi borrowers may use loan proceeds for crypto-related purposes.

These two factors automatically place such borrowers in a high-risk category, making the credit score a key factor.

From a supply-side perspective, the central question is whether the interest rates offered by corporate lending agreements are sufficient to attract crypto-native investors. Obviously, the interest rates cannot be very high, as this would scare off borrowers. To remedy this, the corporate lending DeFi protocol will use the tested DeFi protocol playbook and offer its native tokens to liquidity providers.

We are unlikely to see a significant spike in corporate DeFi lending, but there is certainly room for upside. The growth of these protocols is limited by the speed of new borrower origination, which requires business development teams to market and requires traditional due diligence on borrowers. Competition among such platforms will be very similar to the traditional world, and agreements may even hire executives from banks.

The implication is that in the next few years, when this cycle reverses, we may see the first corporate defaults in crypto lending, which will present interesting legal challenges.

Someone will have to explain to a judge how a decentralized autonomous organization (DAO) can issue loans from an anonymous pool of creditors.

Personal Consumer Loans
Unlike corporate DeFi loans, making low-collateralized loans available to individuals in a decentralized manner is more complex. This is primarily because the underwriting costs of a consumer loan far exceed the expected benefits of originating the loan.

Underwriting costs include due diligence, credit risk assessment, onboarding and potential execution costs. Unlike corporate borrowers, individuals typically seek smaller loan amounts and therefore are unlikely to be able to spread such costs across loan applications in a cost-effective manner.

In addition, consumer lending is also a regulated business in many countries/regions, so successful implementation of DeFi consumer loan agreements is more likely to attract the attention of regulators.

An example of an attempt in this area is Teller Finance (currently in beta). how does Teller, which promises to allow unsecured consumer lending, do this? The answer is by connecting to a potential customer’s bank account and performing a credit assessment based on account history, which is not too different from how traditional finance works today.

When access to a bank account is granted, the loan applicant also discloses his or her identity, which may discourage the current generation of DeFi users.

Teller must rely on bank account history, due to the fact that there is not currently any DeFi native credit score. If credit scores existed that could be reliably associated with a specific loan applicant, Teller would be happy to extend DeFi loans without connecting the customer’s bank account.

This brings us to the concept of digital identity and digital reputation, which is essential for the development of unsecured DeFi lending.

Digital Identity and Digital Reputation
The reason collateral must exceed the loan amount today is the lack of concepts such as digital identity and, in crypto, digital reputation, resulting in a lack of trust that would be handled by overcollateralization alone.

Considering that this area is far beyond the competence of the authors, we will stop here to discuss further the topic of decentralized identity. Instead, we will introduce readers to the standards being developed by the W3C, as well as a short but comprehensive talk by Michael Sena, founder of Ceramic, which will take place at ETHDenver 2021. Now let’s talk about reputation.

Reputation is all the data points associated with identity that allow interested third parties to assess default risk and calculate the creditworthiness of a particular borrower. In traditional finance, a borrower’s creditworthiness is typically evaluated based on the following criteria.

Pay stubs

Bank account transaction history

Credit scores issued by credit bureaus

Savings balance

Past defaults

Number of recent credit inquiries

Lack of criminal record

All of the above data exists in a federal or central registry maintained by the police, banks, etc. They are also usually locked within a specific nation state.

As all of these intermediaries eventually enter the blockchain, we may see the emergence of purely digital credit scores. Initially, such digital credit scores will replicate off-chain scores, giving more weight to financial factors.

However, with the further development of the Web 3.0 technology stack and the advent of Metaverse, digital native factors may become more prominent when assessing creditworthiness. These factors may include

The number of followers in any given social network

Creation of valuable content and other verifiable IP written or owned by the borrower through NFT

Borrower’s history of interaction with DeFi (your wallet is not only your resume, but also your credit score), including participation in governance of major agreements

Participation in grant programs (Gitcoin, etc.), etc.

Ranking in the on-chain virtual world

Guarantees or assurances from other on-chain native subjects (e.g. individuals or agreements)

Using these factors for credit scoring does require decentralized identities rather than the use of national IDs. Several projects are currently trying to address this issue, such as Ceramic, BrightID, and Idena. the team behind Spectral Finance appears to be simply aggregating wallets in an NFT and assigning them an on-chain credit score, but it is unclear how the implementation of non-transferable identities will be handled.

The Future of DeFi Lending
Let’s recap, today’s DeFi lending is dominated by hypercollateralized loans with crypto blue chips as collateral.

The next iteration of this business model is the tokenized NTF as well as the RWA, where liquidity and price discovery are crucial.

Beyond that, given the economics of the underwriting process, low-collateralized loans will be offered to corporate borrowers first, which is the most viable route in the short term. For individual borrowers, the market will also need to address the issue of decentralized identity as well as on-chain reputation in order to access low-collateralized loans.

While DeFi lending has experienced explosive growth, we are still in the early stages. With the introduction of DID and on-chain reputation, DeFi will begin to support more collateral, more institutions, and more forms of lending.

It’s early days yet, and we’re getting better every day.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/the-evolutionary-path-of-blockchain-lending-from-crypto-pawnshop-to-credit-agency/
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.

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