Bank to the future? Borrowing and Lending in DeFi

A massive opportunity

As we have been writing in this series, Decentralized Finance is disrupting the multi-trillion dollar financial industry. A large part of this has been with huge improvements in creating multi-billion dollar liquid collateralised lending and borrowing ecosystem with high efficiency and ability to remove bad debts through innovative mechanisms allowed only by smart-contracts.?

In this article we highlight the:?

• The key differences between TradFi and DeFi with borrowing and lending?
• The innovation - Flash Loans and Liquidations
• Where DeFi hasn't made material inroads and why these are a further areas of opportunity

TradFi vs. DeFi

Much like in the Traditional Financial system, leverage is heavily employed within the DeFi (Decentralised Finance) ecosystem.

However leverage in DeFi typically takes the form of collateralised borrowing, where users can borrow up to the value of their collateral but not any greater. This is in contrast to most traditional finance products like credit cards, where you can borrow without any collateral, or mortgages where the value of the loan you take out can be many multiples of your initial deposit.?

Another major difference between the DeFi and TradFi way of borrowing and lending, is that depositors depositing crypto assets into a Borrow/Lending DeFi protocol are given a new token in return as a certificate of their deposit, which accrues interest over time, and can often be in excess of the interest charged on their borrowing another asset. This enables the possibility of a self-repaying loan.

This mechanism is utilized primarily as a way to access liquidity against tokens without actually selling the deposited token, and is valuable for many reasons, as users:?

• Want to utilize leverage to increase a the quantity of a token they hold
• Think the price of the lent token will continue to go up and want to earn interest on it
• Are forbidden to sell the collateral but want to access liquidity against it
• Carry a heavy tax penalty on realized gains (triggered by selling)

Like all of DeFi, borrowing and lending is permissionless; a smart contract instantly allows you to deposit, withdraw, borrow and repay assets subject to predefined rules. These rules define how the supply and demand for assets affect the different interest rates of the underlying transactions.

This is in stark contrast to a traditional bank where lengthy credit checks and scoring is conducted with an opaque formula determining what you can and cannot do, with next to no flexibility.?

Money markets are massive. The biggest money market protocol, Aave, has USD 2.1B being deposited on the platform currently, although this is down from USD 7B in early Feb 2023, down from the high mark of USD 15.6B in April 2022.

The amount which you can borrow depends on the platform rules, and which individual assets you chose to borrow and lend, with different scores being assigned depending on liquidity and quality.?

Typically, the riskier the collateral you lend out, the less you can borrow against it. If the amount you borrow exceeds the collateral you have posted (including a safety buffer), then your loan will be immediately called, and your collateral is sold off and reduced to repay the loan including a penalty rate.??

There exist many protocols offering this functionality with innovative new twists, such as; Alchemix which offers collateralized loans that self-repay over time, and Arcade allowing digital art collectors loans against their illiquid NFT’s.?

Flash Loans and Liquidations

One of the truly unique concepts within decentralized finance is that of a flash loan, an uncollateralized loan that is taken out and paid back with interest and fees all within one transaction.?

The flash loan is codified in such a way that if the loan fails to be repaid then the whole transaction is reverted and canceled, making it effectively riskless for the issuer.?

These flash loans have many practical utilities; for use in arbitrage trading keeping prices aligned and as an efficient mechanism to clear bad-debt quickly without having to use vast quantities of capital.?

As an example: if a user has breached a protocol's prescribed leverage ratio, (i.e. if they deposited USDC as collateral and borrowed ETH, and the price of ETH has risen significantly, thus breaching loan-to-value limits), a liquidator could then step in and flash loan some ETH and paying back the ETH loan to the protocol, they then collect an equivalent portion of the initial USDC collateral, plus an extra percentage bonus for liquidation. Within the same transaction still, the liquidator would then sell these USDC back into ETH and repay the flash loan plus interest, keeping the extra ETH as profit. This is demonstrated in the diagram below.?

The self clearing mechanism described above allows DeFi to function efficiently, clearing bad debt in a timely manner.?

Of course, each individual decentralized application (dApp) is only as good as the smart contract they are governed by, and some poorly defined protocols have allowed bad debt to exist, but overall the DeFi system held up incredibly well in 2022 in the face of big liquidations, huge reductions of leverage and violent price swings.?

The further opportunity

Thus far, DeFi has been unable to successfully create a scalable model for lending that is unsecured, as we have written about before, as only around USD 2B of loans are undercollateralized. Many of the big crypto collapses in 2022 were caused by opaque lending to firms in an undercollateralized manner, which resulted in big firms like Genesis, BlockFi and Voyager taking heavy (and sometimes fatal) losses.?

However the vast majority of loans made in TradFi and CeFi are unsecured. These rely on the credit worthiness of the borrower with no assets held as collateral against them. This type of lending allows greater leverage and capital efficiency for users but at a greatly increased level of risk.?

New advances in cryptography technology such as zero-knowledge proofs (ZKP) are at the forefront of many of the most exciting current blockchain projects, and could offer exciting solutions to enable and allow this new avenue.?

Sources:

• https://docs.aave.com/hub/
• https://www.imf.org/en/Publications/fandd/issues/2022/09/Defi-promise-and-pitfalls-Fabian-Schar
• https://www.imf.org/-/media/Files/Publications/GFSR/2022/April/English/ch3.ashx
• https://members.delphidigital.io/reports/the-state-of-undercollateralized-defi-lending