Digital Tokens as a Pledge — Smart Contracts & Lending
Digital Tokens issued on Ethereum block-chain network are solving a simple problem in the decentralized world.
Thinking ahead. Past 6 months we have been trying to solve the issue of lending cryptocurrency on the block-chain network. Now that Ethereum block-chain has been running for almost two year, we have not seen a wide use lending Smart Contracts. Why?
Transactions are anonymous. At the moment, when you send Bitcoin or Ether to another address, the address is not associated to any identified person (in theory). This means that if I loan Ether to a third party address, there is no way I could enforce the loan agreement in real life without a sufficient amount of proof (which could be hard to achieve in crypto-world).
You do not lend if you will not get paid back. Due to the design of Ethereum block-chain (and Bitcoin), you are your own bank. This means that if you do not pay a loan back, the borrower cannot charge your account. The aforementioned fact chases away the lenders.
Reputation or rating as an incentive. Borrowers could be encouraged to pay the loan back by using a reputation or rating system. This would mean that if the crypto-borrower does not pay Ether or Bitcoin back, his reputation is affected. Therefore, the borrower might get banned or getting the next loan might get more difficult.
Such a rating system is used for example by the Fiat to Bitcoin Exchange LocalBitcoins. Moreover, there has been discussion on reputation systems within the Ethereum community since the beginning of Ethereum. Later, Consensys started to develop uPort sovereign identity system for building reputation.
Reputation helps to figure out the question: who will I lend to? However, the next question is, how will I prevent the loss of capital on default?
Digital Tokens have value. Digital tokens that have raised capital during the Initial Coin Offering do have value. For example the DigixDAO tokens are bound to gold and each token holder is factually holding part of the gold reserve. This means also that the token is less volatile than other tokens and preserves its value.
These tokens are traded within the exchanges. Since we can calculate the value of the token by following the trade, we can use Digital Tokens for all sorts situations where trust is needed.
Pledging Tokens for a loan. Instead of selling the tokens for Ether, one could pledge these tokens for lending Ether. Therefore, one would not need to get rid off rare tokens or value growing tokens just for the sake that Ether is needed.
Real world example. Pledging digital tokens for a loan mimics the real world scenario on pledging shares, commodities (such as gold), property or art for a loan. It is quite common on Wall Street to pledge shares to get more capital to invest in more shares. The same could be reached in the crypto-world.
On-chain solution. What we wanted to develop was a solution that would be completely decentralized on the Ethereum block-chain. We came up with EthLend. Borrower requests a loan and pledges sufficient amount of any ERC20 Token to cover the loan amount and the premium (interest).
The lender then funds the loan. If the Borrower does not pay the loan back, the tokens are transferred to the lender. Then the lender can go to exchange and change the tokens back to Ether to cover losses. Simple, but practical.