A bank of the future might need a robust new age banking structure to stand on, but a well oiled lending engine is what would truly make it run. Today, India’s credit growth has hit its lowest in decades and most emerging markets, including India, have the worst credit to GDP ratio. There is a need now, more than ever before, to reinvent lending on the blockchain in a crypto economy. A new lending model that is decentralised and global.
What’s wrong with lending?
In order to reinvent lending on the blockchain, we need to understand how lending actually works and what are the flaws in the current lending model.
Today, individuals deposit their savings in a bank, creating a reservoir of funds from which the bank can draw from, in order to lend. But when the bank gives a loan to a customer it is creating additional reservoir of funds since now both the loan and the deposit can be withdrawn. This dichotomy is managed by the central bank using fractional reserve banking which allows only a fraction of a bank’s deposits to be backed by actual cash on hand and be available for withdrawal. This is done to expand the economy by freeing up capital that can be loaned out.
So a bank’s ability to lend isn’t just based on its deposits but the central bank’s monetary policy which is usually a reflection of the prevailing socio economic conditions. But in actual practice, most banks usually lend first and look for reserves later, which in a way ensures that their lending is constrained by capital requirement and not reserve requirement.
While deposits are the primary source of funds for almost every bank, shareholder equity and profits created by the bank are important parts of meeting capital requirement to fund loans. And here lies the seed for a new economic model for lending on the blockchain.
Till recently, before the advent of blockchain and cryptocurrencies, lending has always been localised within a country and governed by the monetary policy of the central bank. Hence, borrowers are limited by the governing conditions of the country. In developed markets with high fiat currency liquidity, interest rates are as low as 1% while in emerging markets, as in the case of Brazil, interest rates are almost 30%. A person with a great credit rating in Brazil has to pay an insanely high amount of interest as compared to the lowest rated borrower in the US. This needs to change.
Cryptocurrencies aren’t affected by local conditions and can provide a global level playing field for all borrowers irrespective of the boundaries they live in. People in the emerging markets would benefit the most from this as interest rates would come down drastically for borrowers thereby enabling more people to avail credit and spurring economic growth. But how do you enable global and decentralised lending on a blockchain?
Lending on the blockchain
Lending on the blockchain isn’t as simplistic as just changing the existing database of a bank or an NBFC to one that runs on a private blockchain. It also can’t be as short sighted as giving fiat loans against your bitcoins as a collateral, to maintain the upside potential of bitcoin. This model is neither practical nor moral due to the crazy price fluctuations. It is not even the right intended use of a blockchain asset. A crypto peer to peer lending model has its merits, where individuals lend their crypto currencies via a lending platform acting as a middleman, with the lender and borrower having a one to one smart contract. There are some companies using this model quite successfully but the biggest flaw with this model is that it increases the personal risk for the lender since now credit underwriting is being done by the individual without any shared risk. This model is scalable only to an extent and can’t be the main lending model for a bank which wants to enable massive credit expansion especially for the unbanked or the underbanked.
A bank of the future needs to solve this in its own unique way. A crypto bank doesn’t have the flexibility of fractional reserve banking at its disposal to lend. Even the existence of an FRB in case of crypto is highly questionable as unlike fiat deposits which can be pooled together, crypto deposits still reside in the blockchain. The answer seems to be creating a new blockchain asset for lending.
A bank can create its own blockchain based lending sub-tokens. These sub-tokens are smart contracts issued by the bank to its users and shareholders which will be used as a currency to lend directly to potential borrowers. A Bank’s user can buy these sub-tokens on its platform directly using any cryptocurrency of his or her choice. This exactly mirrors depositors parking their money in fixed deposits, the interest on which depends on how the bank’s lending function is performing. These sub-tokens will also be made available for purchase to all the bank’s token holders. Subsequently, the funds generated from this sub-token sale will be used to fuel the bank’s lending ecosystem and meet the capital requirement.
Hence, in the new age banking structure, a token is equivalent of getting a variable interest on your savings account; while a sub-token is equivalent to a variable interest on parked funds or fixed deposits.
Any borrower on the banking platform after completing their KYC can avail a loan at an interest rate based on the internal credit scoring system of the bank. They would receive the loan in the form of sub-tokens which can be converted to any fiat currency on the bank’s exchange platform. During repayment the bank would again convert the fiat currency into sub-tokens along with the interest. Since the bank itself is managing the supply of these tokens and the token value is linked to the lending performance, borrowing sub-tokens will always be the best and most feasible option. This ensures that the risk is now decentralised across all borrowers and lenders globally instead of it being concentrated with a single lender. It also passes the benefits of interest earned to drive the value of the sub-token.