Moving Toward Platform Differentiation in DeFi Lending
Currently, the main form of competition in DeFi lending exists in terms of interest rates offered and liquidity provided. In the short run this reality creates a system driven by misaligned incentives. In the long run, competition centered on pricing will have the undesired effect of becoming a race to the bottom. DeFi lending platforms should begin building competitive moats now, not only to create more platform stability within the current system but, more importantly, to be better positioned to capture new market share and sustained success into the future.
DeFi Lending Overview
By providing on-demand liquidity (usually in the form of dollar-pegged stablecoins) to borrowers willing to over-collateralize their assets (usually cryptocurrency), lending solves a major crypto pain point. Namely, crypto holders can gain short-term liquidity without having to fully liquidate an asset that could appreciate meaningfully in the future. On the other end, DeFi lending offers variable interest rates to lenders that far outweigh rates provided by traditional banks — often by 2x — 8x or more — in exchange for bearing greater risk. These risks include protocol, smart contract, liquidity, and asset price volatility risk.
Although it is difficult to compare the size of DeFi sectors, lending is widely considered to be a high-growth and maturing sector in the nascent DeFi landscape, primarily due to the fact that many of the most successful DeFi startups are either lending products (Compound and Aave) or include lending as a major feature of the platform (dYdX). Beyond this, lending is interesting for several reasons.
Whereas other DeFi sectors (like derivatives, exchanges, and asset management) serve to strengthen the DeFi ecosystem as a supplement to centralized finance, lending has the potential to do this while also directly competing against traditional financial products. Specifically, the lender side of lending platforms could, eventually, be broadly viewed as a substitute for traditional high yield savings accounts. The connection is already starting to be made, likely aided by a historically low interest rate environment in the U.S.
From a pure financial product perspective, the lender side of DeFi lending is also the most straightforward product in the DeFi ecosystem — derivatives and exchanges require pre-existing financial education and cater to a more sophisticated set of users — those that choose to deposit savings on lending platforms can gain exposure to a new financial system, in some cases without a pre-existing smart wallet or underlying position in cryptocurrencies. That said, it should be noted that DeFi in general is currently too risky for most mainstream users and requires a great deal of education before investing. Nonetheless, for those that understand the risks and wish to enter, lending, as an inherently consumer-facing product, may be the best-suited on-ramp into DeFi for retail consumers.
While all of this is promising for the future of DeFi, the lending space is still in its infancy. Platforms currently only compete across a limited set of differentiating factors, which has led to a system rife with misaligned incentives. To fully realize their potential as a legitimate alternative to traditional financial products and the front-facing on-ramp into the DeFi ecosystem, lending platforms must start thinking about long-term defensibility now, while they still have the opportunity to create distinct product offerings and unique user experiences.
Misaligned Incentives in DeFi Lending
In the current environment, competitive differentiation in DeFi lending primarily exists in terms of interest rates offered and liquidity provided. On the surface, this seems plausible. When I shop around for student loans or consider where to park my savings account, getting the best rates and ensuring that I can liquidate my funds anytime I want as a depositor are criteria 1 and 1a. Other characteristics like quality of customer service, availability of physical branches, and user experience on an online platform might factor in, but they ultimately pale in comparison to interest rates and platform liquidity. This makes perfect sense in a traditional financial system that includes FDIC-guaranteed deposits, regulations that dictate bank reserve requirements, and usury laws, among other safeguards. Unlike centralized finance though, most major DeFi platforms offer variable interest rates that are determined by their individual supply of deposits and demand for loans, as opposed to rates that are anchored to the broader macroeconomy and fluctuate based on a borrower’s perceived risk profile.
In traditional financial markets, interest rates reveal significant information about the health of the economy and form the basis for almost all asset valuation models. Whether it be for calculating expected return or present and future market value, the interest rate is a key variable based on the lending and borrowing of assets¹.
Whereas interest rates are used to compare relative risk (of assets or people) in traditional financial markets, in DeFi, at least in its current form, interest rates are impacted much more by platform dynamics than by underlying asset risk.
What ends up happening when interest rates are determined at a micro instead of macro level is somewhat counterintuitive. Those platforms that are either (i) new and need to drive up volume or (ii) undersupplied from a deposit perspective relative to demand for loans are able to offer exorbitantly high deposit interest rates, even in comparison to other DeFi lenders. This has the problematic effect of drawing funds away from platforms with solid traction and toward platforms that are unproven or, more importantly, unsecure.
The hacks that took place on the bZx platform in late February, along with corresponding surges in interest rates and deposits, are a prime example of why the DeFi lending space cannot and should not continue to compete on interest rates and liquidity alone. The first attack, which took place on Valentine’s Day, saw a hacker walk away with a $350,000 profit. Two days later, on February 16, variable interest rates on the platform spiked from .07% to 98.18%. This happened in order to replenish liquidity by creating an environment in which lenders would be highly motivated to supply new funds and borrowers would be highly motivated to close outstanding positions.
By February 18, Ether deposits on the platform nearly doubled, followed by a second attack where a hacker pocketed $630,000. Subsequent to the second attack, interest rates remained at ~40%, into early March. Per bZx founder and CEO Tom Bean in early March, “Yes, our high yields are attracting lenders. Two weeks have also passed since the attacks, so lenders have some degree of comfort in starting to use the platform again².”
Similarly, in April, hackers exploited a vulnerability in the lending protocol of dForce, an ecosystem of DeFi protocols based in China. Roughly $25 million in customer funds was lost. Unlike bZx, the protocol was immediately taken offline and its smart contracts were paused. In a bizarre turn of events, approximately all of the funds were returned by the hacker just three days later, though that hasn’t stopped major criticisms of the platform from emerging. Putting aside any argument around what taking the protocol offline in a time of duress indicates about the decentralized nature of dForce, had the protocol remained online, a very similar set of incentives and outcomes to what we witnessed with bZx (i.e., sky-high rates drawing liquidity to an unstable platform) would have played out.
In fairness, bZx and dForce aren’t the first DeFi platforms to get hacked, nor will they be the last. Decentralized finance is inherently risky — that is the tradeoff (at least for now) that comes with foregoing a centralized financial system in search of higher yields. In a system like this, there will always be parties willing to tolerate higher risk for the prospect of a higher reward. However, if DeFi lending is to evolve from a niche set of products, primarily catered towards interest rate arbitrage and crypto margin trading, to a solution that can also support mainstream consumer use-cases, platforms with security issues and lower liquidity should not appear more attractive to new users than more secure, more liquid alternatives.
Perhaps, as the sector matures, volatility driven by security hacks will decline and interest rates across platforms will converge. Even in that environment, without a differentiated product offering, DeFi lending platforms will be forced into competing on pricing, via interest rates, which is a race to the bottom in any market dynamic.
The last major disruption in lending occurred around 2014 in the alternative lending space, led by startups like Lending Club and Prosper. Similar to DeFi lending, these startups garnered a great deal of attention because they were able to generate efficiencies and consumer value that couldn’t be replicated by competing products from traditional financial institutions. Yet, within just five years, this high-growth fintech segment appears to have plateaued, as major players struggle to differentiate from their competitors. Admittedly, the comparison isn’t one-for-one. DeFi lending and alternative lending serve different use-cases and, naturally, operate under different looking business models. Whereas alternative lenders leverage unique underwriting methodologies to profitably serve customer segments that traditional banks cannot (or will not), DeFi lenders serve a small subset of borrowers willing to collateralize loans through their unique protocols. However, understanding these differences, taking a deeper look at the alternative lending space provides useful insights around both riding the wave of growth that stems from sector-level innovation as well as the inevitable plateau that occurs when further innovation fails to take place at the platform level.
Alternative Lending and ‘ The Differentiation Challenge’
Founded in 2005, Prosper Marketplace was the first of the major peer-to-peer lending companies to open its doors. About a year later, Lending Club was founded, and by March 2015, the two companies were collectively valued at over $10 billion³. According to RRE Ventures partner Stuart Ellman, “The reason these alternative lending platforms are coming up is that platform lending is simply more efficient for both the borrower and the lender. The borrower is able to find loans that they otherwise weren’t able to get and lenders have the ability to do their diligence, see the risk and the interest rates, and make the loans they want to on an a la carte basis³.” Ellman’s sentiment matched that of many other VCs in 2015, which may explain the exponential growth in lending platform venture investment throughout 2014 and into 2015.
Yet, while Lending Club and Prosper certainly set the stage for a lending marketplace boom, Ellman and other investors were setting their sights on a new wave of lending players — vertically-specialized lenders. SoFi, best known for its student loan marketplace, raised a $200 million round in January 2015. Soon after, DriverUp, a lending platform for automotive financing, raised $50 million in late February from investors, including Ellman’s RRE Ventures. Dan Ciporin, a partner at Canaan Partners and Lending Club board member summed up the rationale for vertical specialization well saying that “unlike some industries, where if you’re starting to go after certain verticals maybe you’re a little too niche, in this industry, you’re talking about massive markets that are still able to be disrupted³.”
In the midst of all of the hype around alternative lending platforms, some whispers started to emerge. Red flags were raised, cautioning against a lack of differentiation across an increasingly crowded marketplace and the long-term ramifications of competitive market dynamics based solely around pricing. A Forbes article, published in October 2015, referred to these issues collectively as ‘The Differentiation Challenge’. At that time, Forbes author Chris Myers observed that “nearly all of the players in the market, save for an enlightened few, inundate potential borrowers with a strikingly similar array of direct mail, email, and online advertisements. Most of these lenders make credit decisions and deploy capital with similar speed, have a similar cost of capital, and charge roughly the same rates⁴.” He went on to point out that, as a result, all of the major players had nearly identical customer acquisition costs. It was clear, even in 2015, that a systemic lack of differentiation would lead to an inevitable growth plateau, or as Myers put it, an outcome with “ever-increasing costs and increasingly numb customers⁶.”
At the same time, the window around an early source of platform differentiation, underwriting, was closing. Initially regarded as a driver of disruption and defensibility, by late 2015, the sentiment towards underwriting had shifted. “For the alternative [lender]s that claim to be able to assess risk based on non-traditional (namely social) data, the issue is that these types of data tend to be publicly available — thus failing to add much to sustaining competitive advantage in the long run. It’s also difficult to get excited about a company that relies too heavily on its ability to run advanced analytics on commodity metrics⁵.” The absence of platform underwriting as a real advantage was further cemented by behavioral shifts in institutional investors, brought onto alternative lending platforms to facilitate burgeoning loan volumes. “Hedge funds were early buyers, actively selecting individual loans that they expected would outperform the platform’s average underwriting. As the platform underwriting models matured and the opportunities for hedge fund alpha generation declined, institutional buyers largely migrated to passive pro-rata purchases of loans within each buyer’s defined credit box⁶.”
By September 2017, Prosper was forced to raise a new round of financing at less than 30% of its valuation just two years prior — $550 million down from $1.9 billion. Meanwhile, LendingClub, which traded at $123.45 shortly after its IPO in December 2014, was trading at $10.13 as of market close on March 6. Even DriverUp, a vertically-specialized platform, filed for bankruptcy in 2019.
Nevertheless, some alternative lending startups continue to thrive today. Companies like SoFi (student loan marketplace-turned personal finance solution), Avant (caters to lower credit scores), and Affirm (on-demand financing at the point-of-sale) have managed to solve ‘The Differentiation Challenge’ by recognizing that early competitive advantages (e.g., alternative sources of data, machine learning models, and leaner cost structures) were not long-term, sustainable sources of differentiation. Instead, they are building competitive moats by focusing on very specific forms of lending (Affirm), targeting niche customer segments (Avant), and leveraging a diversified platform (SoFi), among other strategies.
Takeaways for DeFi Lending
Given the complexity and ever-evolving nature of DeFi, the future of DeFi lending is uncertain and, I believe, largely untapped. At this stage, the sector is too nascent to deploy some of the strategies that have proven successful in more mature ecosystems. Platforms are limited in terms of use-cases and customer segments that can be targeted, and this will likely be the case until DeFi lending achieves a path towards under collateralization.
That said, while I cannot claim to have any perfect solution for building sustainable competitive advantages, here are a few thoughts on how lending platforms might be able to ease some of the pressures in the current system while setting themselves up to avoid a similar fate to many alternative lending startups over the long run:
Converting Education into Customer Loyalty
DeFi is plagued by the fact that applications are really only used by crypto-enthusiasts primarily residing in developed countries. In many instances, potential future users may not have a strong foundation of knowledge in traditional finance, let alone blockchain, but that knowledge is a critical building block for understanding how cryptocurrencies work as well as how they might be leveraged to create new economic opportunities. Robinhood, which released Robinhood Learn late last year, is an example of a company with a robust set of resources aiming to help break down barriers to interacting with financial markets and cryptocurrencies. For DeFi lenders, educating future users is a prime opportunity to build customer loyalty, while also conditioning users toward a specific set of products and workflows — their own.
Security as a Foundation for Reputation
Clearly easier said than done, security is top-of-mind for many lending platforms. The open-source nature of DeFi protocols and smart contracts makes them particularly susceptible to loopholes and hackers, but while internal security is crucial, another important aspect of security is tied to third party oracles. Partnering with the right kind of oracle (many believe decentralized and non-exchanged based) is key to ensuring security at the periphery of a platform. Coinbase leverages its spotless record of never having been hacked to enhance user trust and build its reputation. By obsessively stress-testing their protocols, permitting regular audits, and connecting with the highest quality third party service providers in the industry, DeFi platforms have an opportunity to do the same.
Smoother Onboarding via Strategic Partnerships
A new wave of users will not only require simpler onboarding processes and streamlined interfaces but also tools that help bridge the gap between fiat money and cryptocurrencies as well as traditional financial markets and decentralized finance. Popular investment apps like Cash App, Sofi, and Robinhood are beginning to offer access to crypto and may look to cross over more into the blockchain ecosystem in the future. The right strategic partnership (or set of partnerships) is all but impossible for competitors to replicate. While there would certainly be regulatory hurdles to consider, could a partnership between a DeFi lender and centralized investment app make sense in the future? These apps could serve as a stamp of approval for the right DeFi lender in the eyes of their massive customer bases. They could also provide a powerful funnel into DeFi through familiar and trusted interfaces.
Conclusion
DeFi lending is an important cog and major building block within the broader decentralized finance ecosystem. While there are still many risks to consider, innovative products and protocols continue to shed light on new use-cases and incentive structures. Although more time and experimentation is certainly necessary before these applications can cater to a mainstream audience, DeFi lenders won’t be able to afford to compete on price and liquidity alone when that time comes.
¹ Kim, Christine. “Here’s Why Interest Rates On Cryptocurrencies Could Be A Game-Changer — Coindesk”. Coindesk, 2020, https://www.coindesk.com/heres-why-interest-rates-on-cryptocurrencies-could-be-a-game-changer.
² Godbole, Omkar. “Yields Of 25% To 42% Lure Lenders Back To Defi Platform Bzx — Coindesk”. Coindesk, 2020, https://www.coindesk.com/yields-of-25-to-42-lure-lenders-back-to-defi-platform-bzx.
³Magee, Christine. Techcrunch.Com, 2020, https://techcrunch.com/2015/03/05/trillion-dollar-alternative-lending-industry-is-a-vc-gold-mine/.
⁴Myers, Chris. “For Alternative Lenders To Be Successful, Differentiation Is Key”. Forbes, 2020, https://www.forbes.com/sites/chrismyers/2015/10/15/for-alternative-lenders-to-be-successful-differentiation-is-key/.
⁵Seo, Tom. “J.P. Morgan, OnDeck and the Future of Alternative Lending”. Techcrunch.Com, 2020, https://techcrunch.com/2015/12/14/j-p-morgan-ondeck-and-the-future-of-alternative-lending/
⁶Michlitsch, Kenneth. “An Introduction To Alternative Lending”. Morganstanley.Com, 2020, https://www.morganstanley.com/im/en-ch/intermediary-investor/insights/investment-insights/an-introduction-to-alternative-lending.html.
