Crypto Lending — The Missing Ingredient
The first crypto-loan primitives
2018 and early 2019 saw an explosion in activity in the decentralized finance space (aka “DeFi” or “Open Finance”). This article will focus in particular on the lending segment within DeFi; this space comprises decentralized applications on which users can borrow cryptocurrency through smart contracts which are recorded on the Ethereum blockchain. The space opened up with the launch of Maker in December 2017 which allows users to borrow Dai stablecoin by staking Ether (ETH) as collateral for the loan and paying interest (referred to as the Stability Fee) in Maker’s native token, MKR. Maker is offering a margin loan product in which borrowers provide security which is larger than the amount of money they want to borrow. If the borrower refuses to repay the loan then their security is liquidated to repay the loan. This form of lending depends on the security value remaining greater than the balance of the loan and with a buffer to ensure that if the asset has to be sold quickly in a distressed market, any decline in price can be absorbed without the loan being underwater. To ensure this is the case, borrowers are able to top up their security position by sending more ETH to the address of the smart contract managing the loan.
The margin loan produce is particularly well suited to cryptocurrency lending because the overcollateralization makes enforcement in cases of default simple and automatic, there is no requirement to link an on-chain address to an off-chain identity for the purpose of collecting bad debts or taking security over a real-world asset like a car. In other words, Maker achieved great product-market fit. Since launching in 2017, Maker has experienced tremendous growth, with over $80m of Dai in current loans outstanding, representing approximately 85% market share (by amount of ETH locked in contracts). The margin loan product pioneered by Maker has since been replicated by other DeFi lenders which have launched, including Compound Dharma, dYdX and Nuo. These platforms have similarly achieved explosive growth with Dharma and Compound now each having originated over USD10m in loans.
While achieving great product-market fit, the margin loan product currently dominating DeFi lending is narrow in usage. Its de facto purpose has been speculation on the price of ETH; lock up ETH collateral to borrow Dai, then purchase more ETH with the Dai. A secondary use-case sees monetisation of gains (in a more tax efficient manner) from an ETH portfolio without sacrificing upside from expected ETH appreciation. Neither of these use cases are what can be called the core benefit/purpose of debt, which is to increase present purchasing power with a promise of future repayment. To explain this conclusion, in each use-case mentioned above, the borrower already has purchasing power via the value of their ETH holdings, if pressed they could simply sell the ETH instead of taking out a loan. It is only in situations where the amount borrowed exceeds the value of the collateral that the core function of debt is being utilised. The margin loan product thus has a limited market because it is not suitable for many common loan purposes such as buying a house or car, financing commercial equipment or providing working capital for a business.
The next stage of crypto-lending
When crypto-loan products become available which are unsecured or under-collateralized (security value less than 100% the loan amount), then DeFi will have a product that can truly eat traditional finance (a la software eating the world) and dramatically expand the global lending market, the same way that the Sony’s walkman expanded the music-listener market. Expansion is more important than disruption; the latter is a zero-sum game where the pie is just cut differently whereas the former grows the pie. DeFi will do this by making access to debt lower cost in terms of time and administrative requirements, as well as in fees and interest rates.
Anticipating the inevitable retort that more debt can only be a bad thing, this article treats access to debt as a tool. Like any tool, its value depends on how its used. Borrowing to fund a lavish lifestyle is unsustainable, on the other hand, borrowing to purchase a car to commute to work, to take a course or to buy inventory for your business is value-accretive.
The key roadblock to unsecured and under-collateralized crypto-loans is that enforcement must pierce the pseudonymity veil to access either a real-world identity or assets. A fraudulent borrower who defaults on an unsecured crypto-loan must be able to be blacklisted from future access to credit in a way that cannot easily be circumvented by creating a new wallet address.
The problem for unsecured lending is that a lender faces only an address and cannot verify that the borrower on the other side of that address will not take out a loan, disappear and then create a new address to repeat the process. There are two perspectives on how to solve this; identity verification, and gamification of the loan product. Identity verification would see borrowers required to submit to a full Know Your Customer (KYC) check to link the wallet address to a real identity that can’t be duplicated. If that address defaulted, the identity could be blacklisted in a database accessible to any crypto-loan provider, and the requirement for any unsecured borrower to match their wallet address to an identity would prevent that borrower from just creating a new address and taking out a new loan. Presently, there are a number of projects working on KYC solutions in which a user’s information (eg passport, address, DOB, drivers license) is stored in a decentralized manner and they retain control over access to that information. A solution here which can plug into DeFi is still a long way off as there would also need to be a publicly queryable blacklist of defaulted borrowers to ensure that a borrower could not perpetrate the same fraud across multiple crypto-loan providers.
The second avenue, gamifying crypto loan products to disincentivize fraud, has not yet yielded results. This approach could take several novel forms, including a bounty for good behaviour, referrals or staking reputation points for related addresses. While the identity verification approach aims to remove the potential for fraudulent actors to hide behind multiple wallet addresses, the gamification approach aims to set up incentives so that fraud is removed or minimized without removing the pseudonymity of wallet addresses. A user could have multiple addresses borrowing from the same platform but would choose to perform because of the threat of punishment for bad behaviour or possibility of reward for good behaviour outweighs the benefit of fraud, all without having to link their addresses to a real world identity.
Blockchain eats finance
Once one or both of these problems has been solved, unsecured crypto-loans will become widely available. At that point, the market of borrowers will expand exponentially because the lending product will no longer only be only suited to speculating on the price of ETH and access to borrowing will no longer be restricted to someone with access to more ETH reserves in excess of their desired loan. Access to credit will be extended to borrowers in regions without a developed financial system. Unsecured or under-collateralized crypto-loans will also be useful for entrepreneurs bootstrapping small businesses. The expansion of the borrower side of the market will be met by the entrance of new lenders. This trend will be strengthened by the overheads of providing finance becoming lower because of the transparency of blockchains for record-keeping and the efficiency they provide in process automation.
Lenders using DeFi platforms to provide loans to customers will need a source of funding. In the traditional financial system, Lenders borrow by issuing bonds to investors which are secured by a portfolio of loans. There is currently no way to do this on blockchain but there will need to be a solution for Lenders to raise funding on-chain to meet the coming wave of borrower demand for loans. This will be the beginning of the crypto-bond market, with bonds at-first secured by crypto-assets. The first crypto-assets beyond Ether or stablecoins to be used as collateral will be revenue-generating ones because the revenues can service the interest repayments. Crypto loans are an obvious example, but other options may include content rights, for example, a writer running an online publication with a subscriber base (paying in stablecoin) could borrow against future subscription fees by redirecting those fees to an escrow smart contract which repays bond investors.
Conclusion: Equality of capital is equality of opportunity
The first primitives of DeFi are margin loans, which are a great start, but new products will need to be created for DeFi to radically reshape the global financial system. Once products which are more useful for commerce are available then far more users will enter DeFi, speeding up the virtuous cycle whereby innovation creates opportunities, opportunities attract talent and talent innovates. There are many visions for what the future holds for DeFi, but mine is for equality of access to capital being a stepping stone towards equality of opportunity. Providing the access to the same financial products globally will enable savings to be invested productively to bring about an increase in living standards in regions with underdeveloped financial systems.
I am personally excited by enabling any budding entrepreneur with access to a smartphone to access finance for their business idea. I hope to write more in-depth pieces on the DeFi lending space and provide analysis on how the space may evolve and the next layer of applications to emerge. Writing these articles is an opportunity to clarify my thinking and connect with open-minded individuals (and hopefully stress debate some of the ideas presented). If you’re interested in the future of DeFi and would like to connect, please reach out to me on here or via twitter.
