Decentralized Finance: P2P Lending on the Blockchain
Abstract
In this paper, I aim to conduct research and shed light on decentralized finance (deFi), an emerging concept in the blockchain space. Decentralized finance has endless capabilities, and those bullish on the technology claim it will soon replace all traditional intermediaries. In theory, decentralized finance will enable individuals to borrow, lend and trade both assets and derivatives in interconnected global markets without the presence of a middleman. Defi promises improved loan accessibility to 2 billion people without a traditional bank account. Perhaps most importantly, deFi is conducive to greater financial transparency.
With this report, I will explain general blockchain technology, smart contracts, collateralized debt positions on the blockchain, and my personal thoughts on its application and effects on the broader market.
The Blockchain Explained
The blockchain is a “chain” constructed of immutable, time-stamped “blocks” of data independent of any central authority. Because the blockchain network has no central authority, it is by nature a democratized system that is transparent and can be made open for anyone to see. Furthermore, the immutable structure of the blockchain makes it costly to attack and one of the most secure technologies to date. Attempts to modify the chain would require broad network approval, making the ledger nearly impossible to hack. The large coordination costs of public ledgers are distributed and transparent, but to avoid these coordination costs, third parties can deploy a private ledger. However, these systems introduce a single point of failure that is more vulnerable to third-party attacks. In sum, the blockchain offers us a decentralized system that is transparent, secure, and fair to use.
Smart Contracts on the Blockchain
A smart contract is a code or piece of code running on the blockchain with certain rules agreed upon by both parties. When these predetermined rules/conditions are met, the contract automatically executes. Not only is the contract automated, but it also inherits the censorship-resistant security characteristic of the blockchain. This immediately and irrevocably enforces the contract without involving costly legal counsel.
Typically, both parties deposit their assets into a contract, which automatically redistributes holdings at completion per the established agreement. A smart contract holds both parties accountable without involving a mediator.
Take the Following Scenario: Jon is renting a house from Alice and has stopped paying rent.
Traditional Process: Alice has to manually lock Jon out of the apartment until he pays rent. This is a straightforward process if Alice only rents out the one property, but Alice likely doesn’t have time to check on each and every property she manages. Furthermore, she would most likely have to rely on legal recourse to enforce the agreements.
Process using Smart Contracts: The smart contract will execute and automatically lock Jon out of his apartment (assuming the room has an electronic lock) until he pays the overdue rent. All tenant’s rent payments verify through the smart contract and Alice’s oversight will be automated.
Collateralized Debt Positions
The CDP (Collateralized Debt Position) is a smart contract that allows users to borrow Dai, a stable coin pegged to the value of the USD (1 Dai will always equal 1 USD), by posting Ethereum, another popular cryptocurrency, as collateral. Most services require collateral of up to 150% of the original loan value to account for fluctuations in unstable cryptocurrencies. If the price of the collateral drops below a certain threshold, the contract automatically liquidates the collateral and the original borrower is transferred ownership of the Dai.
By using smart contracts, users can take part in peer to peer lending without a middleman. This can help reduce fees and eliminate barriers to raising capital. In some situations, companies such as Dharma or Compound facilitate borrowers finding lenders. Because the companies themselves do not provide the assets being lent or borrowed, the transaction fees and barriers to entry tend to be much lower.
Decentralized Finance Today
According to defipulse.com, there are about $419mm in assets locked up in decentralized finance, with about $400.9mm of that locked up in lending. The major platforms used to facilitate this lending include Maker ($356.8mm), Compound($33.6mm) and Dharma ($10.5mm). The marginal amount not used for lending is locked up in decentralized exchange contracts, synthetic derivatives, and payment protocols like the Lightning Network.
Outlook for the Future
Decentralized finance’s nascent technology and open design naturally attract a bullish outlook. With greater use, decentralized finance promises to challenge traditional banking and force adoption of new business practices. Decentralized finance connects people all over the world by providing them with a common protocol for lending and borrowing, drastically increasing the interconnectivity of global markets. It will also help increase the efficiency of lending processes and reduce transaction costs and interest rates to a truer market equilibrium. Traditional fiat economies tend to be quite fragmented, and often represent walled gardens only serving those who are profitable.
As with any futuristic technology, there are significant hurdles deFi must overcome. First, there needs to be greater trust in blockchain technology. This will only come through greater access to information for the general public. The average person tends to associate the blockchain with the crash of Bitcoin prices and views the technology suspiciously. The greater legitimacy the industry needs is a product of time and broader public education. Additionally, there needs to be greater price stability in cryptocurrencies. Posting Ethereum as collateral is often very counterproductive as the price of the currency can be volatile. If the value of the collateral frequently changes, it increases risk and reduces lender incentive. Price stability will only come with increasing investment in the market, ensuring large traders can’t manipulate the prices of currrency.
We are only scratching the surface of decentralized finance. It’s here to stay. That being said, until the industry gains the public’s trust and achieves price stability, it will be difficult to engage laypersons. The upshot is a day when small loans are accessible to everyone independent of credit condition and geographical location.
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