The flippening of the credit industry — How close is DeFi to replacing TradFi?
The cryptocurrency industry represents one of the main threats to the current banking system. Blockchain technology allows for faster, cheaper, and more secure transactions to execute in a decentralized and permissionless environment. There is no need to provide a credit score, wait for months to obtain a loan, or pay exotic fees to someone who evaluates your collateral.
On paper, there would be plenty of reasons why banks cannot stand the competition of DeFi lending and borrowing protocols. However, things are much less straightforward than they look at first glance.
This post aims to walk you through the high-level functioning of credit markets in DeFi, focusing on the differences with respect to the legacy banking system.
Lenders and borrowers — who holds the short end of the stick?
One of the primary metrics used by credit analysts to assess a bank’s solvency is the default rate, namely the percentage of borrowers that don’t pay their debt back. The default rate contributes to determining the amount of own funds the bank has to come up with to cover losses due to unpaid debts. Therefore, the traditional banking system is structurally prone to protect lenders from default risk. Most borrowers receive uncollateralized loans based on their expected ability to repay debt through the cash flow they generate. Banks are then exposed to the risk that their counterparties can’t generate enough cash flows to honor their obligations.
Collateralized loans, on the other hand, are usually backed by assets with partial liquidity and subjective valuations such as real estate. These two elements make lenders in TradFi much more likely to hold the short end of the stick.
In DeFi, the process is reversed: instead of proving the ability to repay debts to lenders, borrowers have to post collateral that fully covers the dollar amount of the loans they want to obtain. Collateral assets are tokens that are supposed to be much more liquid (and so much easier to price) than real estate.
Since the price of such assets fluctuates heavily over time, borrowers are usually required to post more collateral, in dollar terms, than the borrowed amount to cover potential future price depreciation. If the dollar value of the collateral falls below the dollar value of the debt by a certain threshold, the platform allows third parties called liquidators to repay the borrower’s debt and retain his/her collateral. The borrower is then incentivized to constantly monitor his/her position and top up the collateral when needed to avoid being liquidated.
The overcollateralization is a byproduct of the trustless nature of DeFi. Since there is currently no robust way to assess the counterparty’s creditworthiness, trust has to be replaced by prudence. Contrary to TradFi where lenders lose capital efficiency by prudently setting aside funds to cover potential future losses, in DeFi, borrowers lose capital efficiency by posting more collateral than the debt they are undertaking.
In summary, the most significant difference between TradFi and Defi for borrowing is creditability. In TradFi, banks may be willing to lend to you based on your credit score alone. But in DeFi, since everyone is pseudonymous or anonymous, collateral is a must for any borrowings.
Predictability in lending and borrowing — A DeFi vs TradFi comparison
Why should a borrower in DeFi be willing to post $150 as collateral to borrow $100? The main reason is to capture incentives given by protocols.
For instance, a new DeFi project could launch its staking program that gives 100% APR to those who stake the XYZ token on the platform. A user with $150 worth of ETH and no intention to sell it could then be interested in posting it as collateral to borrow $100 stablecoins, buy $100 worth of XYZ with such stablecoins and stake XYZ for three months to earn another $25 worth of XYZ (assuming the XYZ price stays the same). If the cost of borrowing stablecoins is less than 100% APR, the user makes a profit.
Incentives are just an example of short-term opportunities that borrowers want to catch by means of debt. The short-termism of DeFi implies that lenders are exposed to uncertainty in terms of loan duration (most DeFi money market protocols offer open-ended loans that can be repaid at any time) and remuneration (most DeFi money market protocols work with floating rates based on supply and demand of a certain asset).
Two main considerations can be made against this background:
- A. There is a constant need for opportunities (i.e. incentives, euphoric markets) to be captured by borrowers for the DeFi credit market to stay afloat. Although that’s true for the TradFi market, the magnitude of the oscillation is much more pronounced for DeFi.
The charts below show the lending revenues of the European banking sector since June 2019. The maximum revenue drawdown is 3.2%.
The chart below shows the lending revenues of the major DeFi protocols since June 2019. The maximum revenue drawdown is 62%.
- B. Investors with a medium/long term horizon are unlikely to participate in the DeFi credit market because of the impossibility of planning reliable strategies regarding timing and/or return on capital.
These two considerations represent a vicious cycle: markets quickly become too reliant on A without B. In turn, excessive usage of short-term incentives makes it increasingly difficult for new protocols to build products aimed at attracting new investors as of B.
In TradFi, debt is mainly used to finance businesses and projects rooted in the real economy. Many businesses have a predictable demand and can generate a relatively constant stream of cash flows to repay debts.
DeFi is still far from it.
Nonetheless, new lending and borrowing products/platforms have been designed in the last few months to try to overcome these issues. Stay tuned to our blog for Part 2 in the coming weeks to find out more about this.
Disclaimer
The information provided in this article is provided for informational purposes only and does not constitute, and should not be construed as, investment advice, or a recommendation to buy, sell, or otherwise transact in any investment, including any products or services, or an invitation, offer, or solicitation to engage in any investment activity. You alone are responsible for determining whether any investment, investment strategy, or related transaction is appropriate for you based on your personal investment objectives, financial circumstances, and risk tolerance. In addition, nothing in this article shall, or is intended to, constitute financial, legal, accounting, or tax advice. We recommend that you seek independent advice if you are in any doubt.
