Can DeFi Lending Spread Wealth Without Compromising on Core Principles?

Posted by admin on Jul 11, 2022

If you took the collateral out of decentralized lending, you’d have something not only potentially useful, but scalable into the real economy.

So said the Bank for International Settlement (BIS) in June.

The problem is, that requires taking the decentralization of decentralized finance (DeFi), because it would require a trusted intermediary to vet lenders. But the whole point of crypto is to get rid of middlemen.

The BIS argued in its “DeFi lending: intermediation without information?” report that for DeFi lending to become useful outside of DeFi, it would have to work more like traditional lending.

“Due to the anonymity of borrowers, overcollateralization is pervasive in DeFi lending,” the report said.

In crypto lending, token owners put up their crypto to be loaned out — at high rates, and for high returns — to borrowers who put up their own cryptocurrencies as collateral. Generally, you need to put up 125% to 150% of the sum you want to borrow.

If the value of that collateral drops too far, it is automatically liquidated. By and large, these loans are circled back into other, even riskier DeFi schemes, notably staking and yield farming.

See also: DeFi Series: What is Staking?

This is so pervasive that a popular type of DeFi loan is a “flash loan,” in which a sum is borrowed, used and repaid — with interest — in a single transaction.

Danger Without Benefit

But this also kills the democratization of finance that is a true potential use of DeFi, and the BIS wrote that “reliance on collateral also limits access to credit to borrowers who are already asset-rich, negating financial inclusion benefits.”

Which is to say, it’s easy to borrow money in DeFi if you don’t really need it.

Beyond that, DeFi is very dangerous to both borrowers and lenders. For borrowers, the problem is crypto’s volatility means borrowers are often hit with margin calls very quickly, and liquidated.

For lenders, it’s twofold. First, lenders earn money by locking their crypto into platforms that loan it out. However, their losses to hacks have become staggering: By April, DeFi platforms had lost about $1.6 billion to thieves and exploits — more than 2020 and 2021 combined.

Second, the people participating as lenders are far less knowledgeable about crypto and DeFi in particular. In many cases, they are just asked to deposit their funds to earn interest rates on up to 20%, and even more. That sounds like a savings account on steroids, but the reality is that the risks are at least equal to the rewards.

DeFi is “the most dangerous part of the crypto world,” Sen. Elizabeth Warren, D-Mass., said at a Senate Banking Committee hearing in December. “It is where the regulation is effectively absent and — no surprise — it’s where the scammers and the cheats and the swindlers mix among part-time investors and first-time crypto traders.”

Democratization

Uncollateralized lending requires, first and foremost, some sort of credit rating, along the lines of TransUnion, Equifax and Experian.

The problem with that, according to Brendan Playford, founder and CEO of Masa Finance, is that it leaves too many people out of the potential borrowing pool.

For one thing, there are plenty of traditional lenders and FinTech neobanks willing to extend credit without delving into the unregulated and high-fee world of crypto lending, based heavily on those scores to avoid human bias, among others.

But more to the point, he said, it leaves the entire crypto economy out of the crypto credit equation. Having been brought up at the low end of the economic scale in the U.K., Playford told PYMNTS that he hadn’t even had a credit score until well after making a decent killing in early crypto mining.

Even then he found himself “held back by not being able to use capital to build leverage,” coming to the U.S. with no credit score and having to work his way from 350 to the mid-700s, despite having run another successful crypto startup.

“It became very apparent to me, sort of through my learning, how important credit was in building wealth and opportunity,” Playford said.

“The problem with that score is, it takes into account credit card information and bank loans,” he said. “But what it doesn’t currently take into account is any of the existing crypto assets that I’ve had for the last seven or eight years. My particular portfolio is weighted towards on-chain assets — I’m thin file off-chain.”

What Masa does, he added, is collect information from far more sources than what goes into a FICO score and “processes data for people that are traditionally unscorable off-chain.”

More to the point, it acts as an oracle — a source of trusted information that DeFi platforms can use to make decisions and cause blockchain’s self-executing smart contracts to execute. For example, a crop insurance company could use Accuweather data to pay out for a crop-damaging freeze.

Man in the Middle

While that does — potentially — deal with the BIS’ concerns about democratizing DeFi, it leaves two other problems.

One is that the lenders investing in crypto lending programs are often very unsophisticated investors, and now have to not only trust that the crypto lender is honest, risk the market’s volatility wiping them out and try and judge the rating agency that is an unknown commodity, but they also have to rely on far more complex and expensive traditional methods of collection when loans go bad — made doubly complex by crypto’s identity-concealing pseudonymity. (Not that traditional finance industry ratings firms are always that safe, as the subprime mortgage collapse showed.)

As cryptocurrency transactions are publicly available, you can’t have the borrower’s personal identity and financial data open to the world, but must make it available to the lender to make decisions.

Which is where scoring comes in, Playford said.

A smart contract can be given information that has been blinded: For example, the oracle can simply tell the lender if the person meets certain criteria without revealing who they are or what the details of their finances are.

“The smart contract doesn’t need to see that information,” he said. “All the smart contract needs to know is, ‘Is that information available? And can it be revealed when collections has to happen?’ So, a decision can be made on the assumption that all of that has been verified. That’s the kind of verification service we provide.”

If it does go into collections “the underlying individual can be revealed to the funding pool or a collector, or indeed the underwriter, to go out and collect in the normal fashion,” he added.

Which doesn’t seem all that different than what a neobank does, except that the investors don’t really have any regulators to turn to if the DeFi project itself turns sour.

And, at least in theory, DeFi has no centralized management to enforce on.

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