The Evolution of Crypto Lending Systems: A Rollercoaster Journey
What is the essence of ‘finance’? At its core, finance revolves around deposits and loans. Even in ancient civilizations preceding the establishment of our current financial system, records indicate instances of people borrowing money and paying interest when faced with financial shortages. This can be considered the origin of finance. From these primitive forms, we have progressed to witness the birth and evolution of an entirely new form of finance, namely, decentralized finance or DEFI. Some argue, especially post-2022 incidents, that DEFI itself is a bubble lacking fundamental value. They claim it operates more like a multi-level structure, where early investors take later investors’ money, rather than creating substantial value. However, let’s consider the fundamental perspective of finance as mentioned earlier.
In the cryptocurrency market, a significant number of people are willing to borrow money at high interest rates, even if they have to pay dearly. Similarly, many individuals are eager to deposit their funds, seeking to earn money with minimal risk. Could it be that this market possesses a more robust fundamental foundation with an immense demand and supply for loans compared to any other financial market? In this article, we explore how lending platforms in the cryptocurrency market are meeting specific needs and evolving.
Before DEFI, centralized lending platforms (CEFI) took precedence in the cryptocurrency market. Platforms supporting margin trading on centralized exchanges (CEX) were commonly used for borrowing services. Anyone who has tried margin trading has likely encountered funding fees charged on an hourly basis. Have you ever converted this fee into an annual percentage rate? For instance, using Binance’s BTC/USDT as a reference, the basic funding fee is approximately 0.01% every 8 hours, equivalent to an annual rate of about 11%, even when calculated with simple interest. However, funding fees often rise several times, up to ten times or more, especially for altcoins. Those engaged in margin trading are essentially using high-interest loans ranging from tens to hundreds or even thousands of percent. Individuals with a mindset of ‘borrow now, pay later’ or ‘it’s just temporary’ contribute significantly to the substantial demand for loans.
With such high demand, various CEFI lending services emerged rapidly. These platforms streamlined the process by allowing users to earn interest by simply depositing assets on the platform, without the need for complex and risky actions to capture funding fees. Many platforms specialized exclusively in lending services, and major international exchanges mostly offered in-house lending services. Users could deposit not only BTC and ETH but also in the form of stablecoins, which generally offered higher interest rates. The interest rate for USDT deposits remained consistently high, surpassing 8%, even reaching 10%. As the popularity of USDT deposit products unaffected by price fluctuations grew, people began comparing them to traditional banking deposits. However, this comparison momentarily overlooked the truth that high returns come with high risks.
In 2022, amidst the crypto market’s explosive growth fueled by numerous leveraged positions. As the market entered a bearish phase, the value of assets used as collateral began to plummet significantly. Simultaneously, depositor anxiety, driven by market uncertainty, led to mass withdrawals, triggering what is commonly referred to as a ‘bank run.’ The world witnessed the collapse of the largest CEX globally, resulting in bankruptcy and the loss of all customer assets, including lending services. In the domestic scene, a notable CEFI deposit platform also faced bankruptcy. The commonality in these incidents was that asset owners suffered losses due to the centralized management of assets by custodians, with no visibility into how the assets were being handled. These events from 2022 provide valuable lessons, and one crucial takeaway is that lending systems must be decentralized.
AAVE is an example of a decentralized lending platform that addresses this issue. Similar to using CEFI services, users can access the website and execute loans with a few simple clicks. However, the key difference lies in the fact that both asset deposits and loans are facilitated through smart contracts on the blockchain, classifying it as a decentralized service. Tracking transactions on the blockchain allows users to monitor in real-time how their deposited assets are managed, who is borrowing them, and the platform’s financial stability.
The fact that loans can be executed on the blockchain marks an interesting and revolutionary development. Traditional cryptocurrency loans always required collateral as a prerequisite. In a market characterized by strong anonymity and loose regulations, providing unsecured loans based on credit, like traditional finance, was not feasible. However, the introduction of flash loans overcomes this limitation through technology. Flash loans, within a single transaction on the blockchain, both execute and repay the loan. From the lender’s perspective, the repayment of the loan is guaranteed within one transaction, eliminating the need for collateral or credit checks. This innovation enables lenders to offer substantial amounts without the hurdles of traditional loans, while borrowers can easily access significant funds and execute desired actions within a single transaction, repaying the loan with a slight interest.
Is there no downside to decentralized lending platforms? While using AAVE, users often find points of dissatisfaction, primarily related to fluctuating interest rates. Instances where a loan is executed at a low-interest rate, only for the rate to suddenly spike, or situations where the loan has a high-interest rate when initiated, but the deposit rate is low, create challenges. This can be attributed to the fact that decentralized lending platforms lack mechanisms, such as reserve requirements or various regulations and agreements, to stabilize interest rates, as seen in traditional banking systems.
Efforts to address these issues in the decentralized world continually emerge. Recently, decentralized lending platforms have been launched, allowing users to fix interest rates and loan durations, providing more stability. Depositors commit to not withdrawing funds during a specified period, allowing them to receive higher interest rates. Borrowers, in turn, can secure fixed-rate loans for a defined period, reducing the risk associated with interest rate fluctuations. This development aims to provide convenience to both parties and enhance the safety of the lending system in a more structured manner.
Beyond the mentioned challenges, decentralized platforms occasionally face hacking incidents or other problems typically stemming from the market’s immaturity. Achieving the stability and sophistication of traditional financial markets will take time. However, when comparing the nature of incidents and problems between the CEFI incidents of 2022 and the decentralized market, isn’t it clear which one holds more structural advantages? Once DEFI lending platforms, based on the solid fundamentals of loan demand, continue to evolve, a portion of the immense profits that traditional banks currently enjoy will likely become part of the returns for DEFI investors.
Jake Kim, Asset manager at Hashed
