Author | Roman Buzko
Compilation | Wang Dashu, Hu Tao
Today, the main form of borrowing in DeFi is over-mortgage. The borrower wants to get 100 dollars of DAI, and needs to invest 150 dollars of ETH as collateral. Of course, there are products that are trying to make insufficient mortgage loans, but there are no successful examples yet. This article will focus on the various existing and yet to be launched encrypted loan agreements and the possible subsequent on-chain credit loans.
Today’s leading DeFi loan agreement is the pawnshop of the past. As more assets enter the chain, the scope of mortgage will eventually cover NFT and tokenized real-world assets.
However, the current main obstacles are limited liquidity and poor price discovery. The undersecured DeFi loans will first be used for legal entities under the chain, and they have gained a certain momentum of development. For individuals, to obtain under-collateralized encrypted loans, two things are necessary: digital identity and digital reputation.
The main reason all loans in DeFi require over-collateralization is that both borrowers and lenders have anonymous identities in true encryption, and the lender does not know the identity of the borrower and its reputation, and vice versa.
In the absence of any credit score from the borrower, the lender can only provide credit at an amount lower than the value of the collateral. Usually LTV (LTV = loan/mortgage value * 100%) must be lower than 100%.
According to the aforementioned formula, with a $100 DAI loan and a $150 ETH as collateral, the LTV is equal to 67%. Currently, the average LTV in major DeFi lending agreements is between 50% and 80%, depending on the quality of the mortgaged assets. This model is not much different from the practice of traditional pawn shops for centuries. In fact, pawnshops originated in China, some of the most primitive financial primitive currencies that can be traced back to the 5th century AD.
Ancient Chinese Pawn Shop
With the development of the financial industry and the emergence of various intermediaries, the pawnshop model has given way to credit loans. The main difference between the business model of credit and pawnshops is to relax LTV (TVL> 100%), that is, lenders are willing to provide borrowers with loans that are higher than the value of the collateral. The lender will conduct due diligence on the borrower based on the available information and evaluate its risk of default. This requires a non-transferable identity and reliable data proving the credibility of this identity.
The current state of DeFi mimics the crypto pawnshop and promotes excess mortgage lending through autonomous protocols, thus repeating the script of the dark age.
But the industry will move forward. Let’s take a look at the current situation and what may happen in the future.
01 encryption pawnshop
As mentioned above, the pawnshop has expanded LTV-based loans to below 100%. The two main business model parameters of pawn shops are LTV and mortgage quality. LTV depends on the mortgage quality.
In the first generation of encrypted pawnshops, the creditworthiness of the borrower was only reflected by the quality and quantity of the mortgage, but in real life many other factors must be considered to evaluate the creditworthiness of the loan applicant. However, in DeFi, the situation is different due to the pseudo-anonymity of transactions.
Good collateral has many qualities. According to the European Central Bank (ECB) framework, good collateral should be liquid and safe. There is no doubt that BTC and ETH are the most commonly used collateral types in DeFi lending agreements. In addition to volatility, they seem to also meet the above criteria and can be alleviated by the immediate liquidation of stable liquidity on decentralized exchanges.
- NFT as collateral
The next frontier of DeFi pawnshops is crypto assets that are currently difficult to value and less liquid, such as NFT assets.
NFT has grown rapidly in 2021. With the surge of NFT owners, several teams have begun to establish mortgage agreements for NFT, such as NFTfi, Statuser (beta product), PawnFi (just Twitter handle, no product yet).
The problem with NFT is the lack of a fixed price supply, low liquidity and opaque valuation. When the price drops, it is difficult for the system to immediately liquidate the collateral . Given the secondary nature of the market, knowing when prices actually fall is equally challenging.
One of the ways to solve the lack of liquidity and price discovery is to tokenize NFTs into ERC20 and trade on DEX. NFTX and NFT20 are doing this.
Of course, there are many types of NFTs, and the question is which type of mortgage loan should be used as collateral for DeFi loans first. Based on the collateral quality mentioned in the aforementioned ECB documents, the most liquid and easily valued NFT will be given priority to become the collateral in DeFi lending.
So as mentioned earlier, tokenized NFT will be the first to become collateral, followed by NFT assets from games and metaverse . The reason is that game assets usually have specific digital utility (more advanced skins, stronger weapons, etc.), and they are also more likely to have continuous price supply and deeper liquidity in their respective ecosystems. However, NFT assets to be used as game assets should not be isolated by the corresponding game ecosystem.
- Real world assets
After traditional encrypted assets and NFTs, the next generation of collateral is tokenized real world assets (RWA). Legal currency, real estate, gold, securities (stocks and bonds), invoices, tickets, etc. can all be used as collateral for borrowing on the blockchain.
Fiat currency and real estate have been tested as collateral in the DeFi lending agreement (USDC in MakerDAO and RealT token in Aave). In addition to the standard quality of qualified collateral, tokenized RWA is also affected by the special risks arising from the tokenization process.
1) Is there an issuing entity behind USDC, such as Circle Internet Financial Limited?
2) How transparent is the issuing entity?
3) Are the reserve assets auditable?
4) Where are the assets (banks, custodians, etc.) actually held in real life?
5) Do these assets require any specific storage or maintenance procedures (for example, gold)?
6) If the issuing entity is a country, what are the political risks?
7) In the event of a default by the borrower, is there a reliable legal enforcement framework to rely on?
In addition, certain RWAs may be subject to special rules, such as KYC/AML and transferability requirements. These will affect the scoring of such assets for mortgage purposes, and may even make such assets impossible to trade on a global scale.
Therefore, the encrypted pawnshop must meet two conditions to switch from overcollateralization to more capital-efficient borrowing methods: digital identity and digital reputation.
02Cryptocurrency Credit Institution
The transition requirements from the business model of the pawnshop to the credit loan (under-mortgage loan): the non-transferable identity of the borrower, and some information about its creditworthiness (credit score).
The identity should not be transferable, because otherwise the lender will never be able to determine who is behind the identity and whether the credit score really belongs to the individual.
- Enterprise DeFi lending
From a legal point of view, there are two types of actors in this world: natural persons (individuals) and legal entities (companies). The former has been around for a long time, but the latter has only appeared relatively recently. One of the earliest legal entities was the Dutch East India Company (VOC) established in 1602.
In this sense, the age of a legal person is 1/750 that of a natural person. However, compared with individuals, companies are the first to obtain DeFi loans with insufficient collateral. Projects under construction in this field include: TrueFi, Maple Finance, Goldfinch, Centrifuge.
These agreements look more like traditional banks. They originate from borrowers, assess their creditworthiness, and sign legally binding loan agreements.
The main difference between these agreements and conventional banks is the source of funds. Banks obtain funds from deposits, and these agreements obtain financing from local investors in cryptocurrencies that are anonymous (such as TrueFi) or non-anonymous (such as Centrifuge).
The borrowers of these agreements are usually well-known brands in the crypto industry, such as crypto exchanges, miners, and crypto funds. This can be used as a credit scoring agent to ensure that the value between the borrower and the lender is consistent.
Whether corporate DeFi loans will achieve measurable goals depends on whether these agreements can meet demand and supply.
From the demand-side perspective, the question is whether these platforms will be able to initiate enough corporate borrowers and willing to obtain cryptocurrency loans at a given interest rate.
Potential crypto DeFi borrowers are likely to be companies (or DAOs) that cannot obtain loans in traditional financial markets (banks, bonds, etc. credit lines). In addition, crypto DeFi borrowers may use loan proceeds for crypto-related purposes.
These two factors automatically place such borrowers in the high-risk category, making credit score a key factor.
From the perspective of the supply side, the focus is whether the interest rate provided by the lending agreement is sufficient to attract crypto investors. Obviously, the interest rate cannot be very high, as this will scare away borrowers. To make up for this, the DeFi protocol that operates corporate lending services can provide its native tokens to liquidity providers.
We are unlikely to see a substantial increase in corporate DeFi loans, but there is certainly room for it. The growth of these agreements is limited by the speed of initiation of new borrowers, which requires marketing by the business development team and traditional due diligence on borrowers. The competition between these platforms will be very similar to the competition in the traditional world, and some agreements may even hire bank executives.
The implication is that when this cycle reverses, we may see the first corporate default on crypto loans in the next few years. This will bring interesting legal challenges.
Someone must explain to the judge how the Decentralized Autonomous Organization (DAO) issues loans from groups of anonymous creditors.
- Personal consumption loan
Unlike corporate DeFi loans, it is more complicated to provide insufficient mortgage loans to individuals in a decentralized manner, mainly because the cost of underwriting a consumer loan greatly exceeds the expected benefit of issuing the loan.
Related costs include due diligence, credit risk assessment and potential execution costs. Unlike corporate borrowers, individuals usually seek smaller loan amounts, so it is impossible to allocate such expenses in a loan application in a cost-effective manner.
In addition, in many jurisdictions, consumer lending is also a regulated business, so the successful implementation of the DeFi consumer loan agreement is likely to attract the attention of regulators.
A well-known example in this area is Teller Finance (currently in beta), which promises to allow unsecured consumer loans. How to do it? Credit evaluation is performed by connecting to the bank account of the potential customer and based on the account history. It is not much different from the way of working in TradFi today.
When granting access to bank accounts, loan applicants will also disclose their identities, which may deter the current generation of DeFi users.
Due to the lack of any other DeFi native credit scores, loans must rely on bank account history. If there is a credit score that can be reliably associated with a particular loan applicant, Teller will be happy to expand DeFi loans without connecting to the customer’s bank account.
This brings us to the concept of digital identity and digital reputation, which are essential for the development and full potential of unsecured DeFi loans.
- Digital identity and digital reputation
The reason why the collateral must exceed the loan amount today is the lack of concepts such as digital identity and digital reputation, resulting in a lack of trust that can only be handled by over-collateralization.
Reputation is all data points related to identity, allowing interested third parties to assess the risk of default and calculate the reputation of a particular borrower. In centralized finance, the reputation of borrowers is usually evaluated based on the following conditions: payroll, bank account transaction history, credit score issued by credit bureaus, savings balance, past default values, number of recent credit inquiries, and lack of criminal records.
All of the above content exists in a centralized registry maintained by the police, banks, etc. As all this information finally enters the blockchain network, we may see the emergence of purely digital credit scores. Initially, such digital credit scores will replicate off-chain scores, thereby paying more attention to financial factors.
However, with the further development of the Web 3.0 technology stack and the emergence of Meta Universe, digital factors may become more prominent when evaluating reputation. These factors may include:
1) The number of followers in any particular social network
2) The borrower creates valuable content and other IP addresses through NFT (verified or owned by the borrower)
3) The history of the borrower’s interaction with DeFi (your wallet is not only your resume, but also your credit score), including the governance of the main agreement
4) Acts of kindness through participation in grant programs (Gitcoin, etc.)
5) Ranking in the virtual world on the chain
6) Guarantees from other entities on the chain (such as individuals or agreements)
The true use of such factors for credit scoring requires the use of a decentralized identity, not a national ID card. Several projects are trying to solve this problem, such as Ceramic, BrightID, and Idena. It seems that the team behind Spectral Finance is just aggregating the wallet into an NFT and assigning it an on-chain credit score. However, it is unclear how to handle the implementation of non-transferable identities.
03 The future of DeFi lending
Let us summarize. Today’s DeFi lending is dominated by over-collateralized loans, and crypto blue chip stocks are used as collateral.
The next iteration of this business model is the tokenized NTF and RWA. Liquidity and price discovery mechanisms are crucial here.
In addition, taking into account the economics of the underwriting process, loans with insufficient mortgages will be first provided to corporate borrowers. This is the most feasible method in the short term. However, for a single borrower, to obtain insufficient mortgage loans, the market needs to solve the problems of decentralized identity and on-chain reputation.
Despite the surge in DeFi loans, we are only in the early stages. With the introduction of digital identity and reputation on the chain, DeFi will begin to support more collateral, more institutions, and more forms of loans.