The “lending” or credit market is one of the fastest growing areas of the DeFi market. According to Statista, this business segment now accounts for almost half of the total transaction volume of the DeFi market (about 40 billion US dollars).
Most experts believe that the DeFi market is yet to grow exponentially due to its advantages over the traditional lending market.
The reason for this is the rapid increase in the number of potential lenders. Due to DeFi’s open design, any cryptocurrency user can become a lender if they are willing to take the risk. At the same time, the credit risk is lower in a decentralized system because the information about the borrowers is sometimes more transparent than in the classic financial system.
DeFi offers many benefits to borrowers
The decentralized market offers significant financial benefits to borrowers as they can connect with lenders without third parties. Also, borrowers can interact with multiple lenders at the same time, forcing lenders to lower their claims.
Lending and borrowing in the form of cryptocurrencies has become extremely popular since the lending protocols Aave and Compound exist that allow users to offer cryptoassets for interest or use their current value as collateral to lend other assets. However, analysts criticize that these platforms work more like pawnshops and not like banks. The platforms require borrowers to overcollateralize their loans. When taking out a loan must average 120% of the loan amount be secured.
The inefficiency of this system is obvious. For example, if you need to deposit $120 in collateral to get a $100 loan, it only makes sense for a very limited set of trades, such as short-term speculation or leveraged trades. Nevertheless, this model is currently the most popular credit model in the DeFi market. The usual methods for evaluating the reliability of borrowers (a credit rating) are not used in decentralized finance. The reason for this is simple. Almost all transactions are processed anonymously, making it simply impossible to create a credit check for a borrower.
Overcollateralization is the biggest hurdle for the DeFi market
It is becoming more evident by the day that over-collateralization of loans is the biggest impediment to the advancement of decentralized lending and the entire DeFi market. And the crisis is just around the corner. According to a recent Report by Messari In the third quarter of this year, liquidity providers on Compound received the lowest returns on their contributions since the platform’s launch.
The fall in interest income is largely due to the influx of new lenders who are also looking to make a profit. While loan volume is still growing faster than total deposits (57% vs. 48% in the current quarter), the gap is closing at an accelerating rate. It is expected to be gone completely soon. Or in other words: The supply of credit soon exceeds the demand for credit. That could result in a sharp drop in lender revenue and a Collapse of the decentralized credit market to lead.
According to Messari, in the third quarter of 2021 alone, lender revenues fell 19% (from $96 million to $78 million) due to lower lending rates. The DeFi industry must therefore lend with little or ideally no collateral for this trend to reverse.
The impending stagnation in the lending market
Other projects focus on protecting customers from crypto market and crypto lending market volatility. So, fixed rate loans are trending now. in the June 2021 Compound Labs announced a product called Compound Treasury. With the new product, users receive a guaranteed fixed interest rate of 4% per year. Compound anticipates the product will bring increased US dollar liquidity. This in turn has a positive effect on the interest rates for borrowers.
Nevertheless, these measures can only delay the crisis in the decentralized credit market. The DeFi market cannot reach the next stage of development without the introduction of decentralized corporate lending. The problem is that companies will never take out loans with full collateral.
The future belongs to bonds
So how to solve the aforementioned problem? Few projects have risen to this challenge. Compound Labs’ main competitor – the Aave platform – is co-developing a new form of unsecured lending a new credit model. In this variant, the responsibility for securing the loan is shifted to the borrower. The latter is then responsible for collecting the claim. The end customer receives a loan that is only partially or not at all secured. However, the involvement of the credit insurer in the lending process clearly makes the loan installments more expensive for the borrower and reduces the profit for the lender.
Cream Finance introduced a similar mechanism earlier this year with the Iron Bank credit service. Undersecured loans are made to a limited number of nominees who have been pre-screened by Cream Finance professionals for reliability. However, it’s still unclear how Cream will compensate lenders if an eligible borrower fails to repay the money.
Another new project – DeBond – developed a system, which is based on the established practices of the traditional credit market. The company offers debt financing in the form of “bonds”.
A potential borrower must deposit digital assets in a smart contract and specify the parameters of the loan, including the term, amount, interest rate and the amount of each loan payment. In addition, the user can choose all these parameters individually based on their own needs and capabilities. These smart contracts are similar to a classic loan in that the borrower can choose the parameters of the loan – with a fixed or variable interest rate. This smart contract is then placed on an electronic auction platform, where the lender can then buy the bond at attractive conditions. The issuer gets a loan and the lender gets a pledge and their money back. The smart contract manages the warranty claims. But that’s not all.
The new EIP-3475 algorithm used by DeBond allows the lender to issue derivatives on outstanding loans and bundle them into new bonds with different risk and reward combinations. These derivatives can be traded on the secondary market on DeBond’s platform. This is how credit risk is shared between the liquidity providers. Compared to current DeFi lending protocols, this translates into a major advantage for the lender. The main benefit for the borrower is that collateral does not have to be liquidated if its value falls below the existing 110-150% threshold.
Will DeFi be one of the most important international financial markets?
Bonds are currently the most important corporate financing instrument. At the end of 2020, US dollar-based bonds were worth nearly $21 trillion. That’s more than 132.5% of nominal US GDP. For comparison, if we apply the same ratio to the total capitalization of the DeFi market, which is just over $52 billion, then the possible size of the DeFi bonds market is over $50 billion.
If the DeFi market manages to create instruments similar to traditional bonds/loans, then the DeFi market could become a significant area for corporate debt and an influential part of the overall global financial market. Cream Finance has at one of his presentations rightly pointed out that the $70 billion direct bank lending market “is a drop in the bucket when compared to the size of all US corporate debt, which surpassed $10 trillion at the end of 2020 to have.”
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