DeFi-Based Lending Improves Global Lending
Through the example of MakerDAO’s CDPs, it’s easy to see how lending can be fair for all.
Why Traditional Lending No Longer Works
As Ray Dalio famously said last year, “the world’s gone mad and the system is broken.” Global lending, which is one of the spaces he spoke of, bears some examining because it’s the major target of DeFi services and continued DeFi development right now.
Ask yourself right now: what are the requirements for successfully obtaining a loan?
In other words, what metrics do banks and other financial institutions look at to determine who gets a loan or who doesn’t?
Since I’m from the United States, I’ll frame this discussion in the sphere I know the best.
Overall, in the USA, it all comes down to credit scores. As a general rule, the higher your score is, the more likely you are of being approved for a loan with a low-interest rate. What many people don’t understand about such a system, however, is that as technology has advanced, more and more metrics have been brought into your credit score.
For example, in the past, your credit score only used to include your history with your credit accounts, i.e., what you did over time with your credit cards.
Now, it’s evolved to essentially include all of your online and even offline spending habits, thanks to data-sharing and machine learning.
Access to loans is now driven by the surveillance state, which knows everything about you and your spending habits.
Where DeFi Comes In: MakerDAO and Collateralized Debt Positions
With DeFi lending services, a better, safer lending system is emerging.
DeFi lending services like Aave and MakerDAO eliminate the need for credit scores as a barrier to entry because they use over-collateralization ratios to protect lenders and the system from borrower risk.
If you don’t know what such a ratio is yet, consider this situation:
Mark wants to take out a loan for 1000 DAI, which is MakerDAO’s native stablecoin. To do so, he has to begin by offering up one of Maker’s supported deposit currencies (those you can deposit in exchange for loans). One of these is Ether, the native currency of the Ethereum network.
Because DAI is classified as an ERC-20 token, it isn’t possible to just exchange Ether for a DAI loan (it is possible to buy DAI on the other hand at the market rate).
Instead, users of the MakerDAO DApp(an app on a blockchain) need to use Ether to purchase what is called “wrapped Ether.” As mentioned in Deepit AG’s explainer of the process as well as on Maker’s site, wrapped Ether is just a representation of Ether as a token on its own network.
If that sounds confusing, don’t worry.
To truly understand wrapped Ether, it’s important to already be familiar with the ERC-20 standard, which is the set of rules that tell developers how to make cryptocurrencies that live in Ethereum smart contracts (Ethereum-based Altcoins) and how those Altcoins can be transferred/exchanged for each other directly.
As the wrapped Ether or “wETH” website points out, because Ether came before the ERC-20 standard, it couldn’t be traded directly for ERC-20-based Altcoins. Instead, in a basic sense, it had to happen on centralized services, i.e., cryptocurrency exchanges like Coinbase, Binance, and Kraken. That meant that both increased trading fees and overall, increased settlement times(the time it takes for a trade/exchange to be completed).
So how exactly does wEth improve matters?
wEth eliminates the need for those services because it allows traders/general crypto users to exchange it for any ERC-20 token, at any time.
What is a CDP and how does it work?
MakerDAO adopted wETH to facilitate the near-instantaneous issuing of DAI loans called collateralized debt positions (CDPs). Though these may sound complicated, they really aren’t.
To understand them, let’s circle back to Mark, who wants a loan for $1000 in DAI, using Ether.
Now he has his wEth and to continue and enter a CDP, he needs to send it to one of Maker’s special smart contracts. Remember that a smart contract is
Think of this part of the process as offering collateral in exchange for a loan, which refers to paying off a percentage of the loan up-front. In Maker’s case, all collateral is always set higher than the loan’s amount to keep its lending system stable.
Currently, this “over-collateralization” is represented by 150% of the loan amount. So, in Mark’s case, because he wants $1000 DAI, he’d have to provide 150% of that as collateral in wEth. What that turns out to be in US Dollars depends on Ether’s value at the time, which can fluctuate wildly.
Because of this, over time, Maker has introduced the ability for interested users to deposit stablecoins in exchange for DAI loans so that no aspect of their loan moves too far in value.
Currently, the only one that the DApp supports is USD Coin, which is a cryptocurrency pegged to the value of the US Dollar ($1 a coin). Here’s to hoping that the Maker community continues to introduce support for stablecoins so that the system stays secure against possible volatility-induced crashes.
For now, Maker lives on, and using its example, all sorts of services like Aave, Compound, and Synthetix have surfaced this year, looking to innovate on decentralized lending.
So, why is decentralized lending better overall?
Now, DeFi lending is its own space, holding more than $3 billion in value, since DeFi is becoming its own industry, anchored around lending.
Decentralizing lending as DeFi groups have done, eliminates the need for banks and allows anyone to get a loan at any time, as long as that loan is in a currency that existing platforms support. With this year’s rise in decentralized lending services, the crypto space is truly becoming a contender to replace/augment the global financial system.
In both systems, loans drive growth, but in the DeFi system, average investors and not banks truly own the entire system’s collateral. Furthermore, loans aren’t taken out on credit but with collateral.
Just like the crypto industry, DeFi’s moving at a lightning-fast pace.
Therefore, decentralized lending has already eclipsed this point to include new systems like “flash loans” and the suggestions of “reputation-based” loans.
Catching up on these and all other developments have never been more important. With that in mind, stick with me here on this blog and at NBX over time if you want to keep up with the developments in this space and the crypto space at large.
For now, I hope you’ve enjoyed this brief discussion.
I’m currently reading Ray Dalio’s Big Debt Crises as well as Steve Ward’s Bulletproof Trader and plan to bring ideas from those works as well as my continuing DeFi research into future posts. Until next time, if you’re not acquainted with DeFi yet, check out my other posts for a developing overview of the space. Furthermore, let me know what you think about the ideas we’ve discussed here below and on Twitter, and stay tuned for a deeper dive into global debt and DeFi, down the road.
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