Decentralized credit and loans: better for borrowers and better for the economy.
In the feverish quest to decentralize anything even remotely open to decentralization, one of the most promising areas is finance and the financial industry. This shouldn't be too surprising, given bitcoin and the origins of blockchain technology, but at a time when even babies are being put “on the blockchain,” the emergence of decentralized finance (DeFi) provides welcome proof of crypto's real utility and applicability.
And while DeFi is covering a wider range of areas — from remittances to derivatives and investments — its most promising sector involves credit and lending. That's because, thanks to the openness, security and transparency of blockchains, it's possible to make loans and credit available to a larger pool of people than ever before, while the interoperability of blockchains opens up the possibility for creating a spectrum of new lending products and services.
But even though the sector has expanded considerably over the past year or so, decentralized finance still needs to put in plenty of work before it can compete with legacy financial systems. At the same time, users need to be careful when using early stage and untested DeFi platforms and services, just as they need to be aware that not all DeFi systems are truly decentralized.
The big decentralized lenders
DeFi might be a relatively new and ill-defined term, but its meaning is simple, referring to the use of blockchains, cryptocurrencies and/or smart contracts in providing financial services to clients. And when it comes specifically to loans and credit, there are numerous platforms, services and companies that are harnessing decentralized ledger technology for the purposes of lending services.
The most well known of these is MakerDAO, which lends its stablecoin — DAI — to users, who gain their loans by depositing ether (ETH) with the Maker system as collateral. According to the recently launched DeFi.Review website, it's the biggest decentralized finance platform by a comfortable margin, having roughly $508 million in ether locked up in its platform. Behind it is EOS REX, which has deposits of EOS worth around $437 million, and which lends to users who want extra EOS in order to stake the cryptocurrency for extra CPU/NET bandwidth on the EOS blockchain.
Both of the platforms above are infrastructural, in that they serve primarily to support crypto economies and ecosystems — be this the EOS blockchain in the case of EOS REX or various cryptocurrency markets in the case of DAI. As such, they arguably don't satisfy the common sense or traditional definition of lending and credit, given that they aren't awarding loans to the general public. Meanwhile, the fact that they both account for approximately 86% of the total amount of assets locked up by DeFi platforms (according to DeFi.Review) is an indicator of how young the sector still is.
Why lending is better when it's decentralized
Nonetheless, as young as DeFi lending may be, there are many other platforms besides MakerDAO and EOS REX that are offering credit via decentralized means. Launched in September 2018 and having around $42.4 million locked up, Compound is a decentralized money market where you can lend your own stores of crypto in order to earn interest, while the peer-to-peer lending platform Dharma was launched in April and has roughly $23.91 million locked up, either as ether or DAI. On top of this, there's a long list of competing platforms, including Cred, BlockFi, Lendoit, SALT, NUO, ETHLend and Colendi.
Another one of these new DeFi lending platforms is Bloqboard, which lets users borrow or lend a range of crypto assets on the Ethereum blockchain, from Wrapped Ethereum to BAT, ZRX and DAI. Its dashboard is fairly simple, with visitors being able to choose to borrow or lend any supported crypto and with them being presented with the variable interest rate they'll benefit from or have to pay. It also enables customers to use Ledger or MetaMask to interact with the Ethereum blockchain and track their transactions. And as Bloqboard's head of growth, Nick Cannon, explained to Cointelegraph, such transparency is a big part of the reason why decentralized lending and DeFi more generally is likely to take off.
"DeFi brings magnitudes greater accountability and transparency to investors making for a healthier financial system. These products will broaden access to sound financial investments no matter what geography you reside in."
On top of greater accountability and transparency, decentralized finance will also bring the benefit of greater security for users and their funds, something pointed out to Cointelegraph by Guillaume Palayer, a co-founder of decentralized crypto asset management platform Betoken.
"The main advantages are the control, security and permissionless nature offered for the end users by DeFi products," he said. He went on, saying:
"Permissionless because everyone can access it without conditions and independent of your local financial system's health. Security and control because the vast majority of DeFi products are non-custodial and offer the option to opt-out of their service with a simple transaction."
As both Palayer and Cannon suggest, the decentralized and geographically nonspecific nature of blockchain means that DeFi lending is more open to a wider market of customers than centralized alternatives. But in addition to this, decentralized lending is more open in a financial sense, and for two primary reasons.
First of all, most blockchain-based credit platforms don't actually require users to have a good credit score or even a credit history, with many covering the risks they take on by requiring collateral — often in the form of crypto — from borrowers (as in the case of MakerDAO, for instance).
"With a decentralized loan, you're not dependant on having access to a credits system and you are able to customize the duration and the cost of the loan however you want," Palayer explained. "As far as I know, no centralized loan providers offer this kind of advantage in a trustless fashion."
“As long as you have crypto assets, you can immediately borrow cash that is delivered straight to your local bank account.”
Nexo claimed to have issued $300 million in loans to over 170,000 users in the seven months leading up to March, while Trenchev also reports that the use of blockchain and crypto-based collateral means that loans can be made extremely flexible for users, both in terms of the amount borrowed and in terms of the conditions attached to lending: “There is no fixed repayment schedule, no strict maturities. As long as you have sufficient collateral to secure your borrowed funds, you have the flexibility to repay your loans at any time with cash or crypto assets.”
Secondly, in many cases, the decentralized, blockchain-based nature of DeFi lending systems allows companies to offer credit at a lower cost, something that obviously makes obtaining loans more affordable for a wider group of people. “Borrowing and potentially the costs of payments in distributed systems are lower,” Alexey Ermakov, the CEO and founder of decentralized payment apps Aximetria and PayReverse, said. He continued:
“Among other reasons, this is due to the fact that in the case of blockchain-based credit systems there are no compliance costs and/or they are significantly lower, and costs are also lowered by the ability to make electronic mortgages and provide loans on the basis of smart contracts.”
Feeding into the openness of decentralized lending platforms is the burgeoning area of blockchain interoperability and atomic swaps, which promise to give users more options when taking out loans or lending crypto.
"Another huge advantage that stems from DeFi's permissionlessness is interoperability," Palayer said. "You could take out a DAI loan from MakerDAO and convert it to Ether using Uniswap or Kyber Swap to gain leverage. The possibilities are endless, and we feel everyone should be excited about this."
And from a more general and macroeconomic perspective, the increased openness and accessibility of decentralized loans should result in higher productivity for the global economic system, as outlined by Cannon:
"As the market matures, decentralized lending services will source more 'dead capital' from around the world."
Put differently, blockchain-based loans will have the effect of putting “dormant” crypto to work in the wider economy, with hodlers having the opportunity to borrow or lend without ever renouncing the underlying ownership of their cryptocurrency.
“Many have been purchasing cryptocurrencies as a very long-term investment, expecting their value to grow hundreds even thousands of times,” Trenchev explained. “Naturally, such investors do not use their crypto for payments. They do not trade it. They simply keep their assets with the expectation of having exponential returns by just holding.”
Future challenges and future promise
There's little doubt that the world of blockchain-based lending is a tantalizingly promising one, but the fact that it's still in its infancy should give potential customers and the industry more generally pause for thought.
First of all, the vast majority of DeFi platforms are still untested and in development, and as SALT's head of product, Rob Odell, told Cointelegraph, this means that users should be careful when choosing a service:
"Be vigilant about researching your options,. For all its advantages, most DeFi applications are still very new — they need time to work out all the kinks and be battle tested."
Odell also noted that users should consider "how limited the offerings of some of the DeFi loan products can be. For example, right now, MakerDao only works with Ether," and while MakerDAO is (like certain other platforms) planning to add more cryptocurrencies in the near future, its current limitations are one indicator of how much distance DeFi has to travel before it can compete on the same level as legacy systems.
As with pretty much every area in which blockchain technology is being applied, education will be one of the first key areas in ensuring that DeFi can expand, mature and realize its potential. "There are a number of challenges but I think education is the greatest," Jeremy Lam, product lead at OmiseGo, a finance-oriented scaling network for Ethereum, said. He added:
"DeFi platforms will often require the capacity of the individual to be in control of their own private key. I don’t think most people are ready to handle such a responsibility. Also related to education, we have to consider who is using DeFi services. How do we protect people with insufficient financial knowledge from losing money on products they don’t understand?"
One thing that potential users need to be educated about is that some DeFi platforms will be more — or less — decentralized than others, something that could potentially put them and their money at risk. "A Service provider needs to fulfill certain conditions to be a true DeFi service,” Stani Kulechov, the CEO and co-founder of the Swiss-based AAVE, which runs the Ethereum lending service ETHLend, warned. He went on to say:
“First and foremost, ensure that the service provider does not hold your assets. This means that there must be a smart contract that holds the funds and secondly ensures that the transactions are conducted via smart contract and not through a third party signing. You should choose DeFi projects based on transparency and track record.”
More fundamentally, decentralized lending won't succeed and make significant headway until the industry pinpoints — and builds itself around — gaps in the credit and loans market it's well-positioned to solve. "As mentioned, education is a large challenge," Lam said.
"The other huge challenge is to properly understand what problems DeFi is trying to solve and onboard the users that are experiencing that pain."
And while there is certainly a demand for loans that don't require a credit history, the fact that most no-credit DeFi platforms ask for crypto as collateral would mean that the success of such platforms is predicated on the general and widespread adoption of cryptocurrency.
And while we certainly haven't yet reached the “widespread” adoption of crypto, there is some indication that adoption has increased in recent months, with around 9% of Americans now owning bitcoin (according to an April self-selected survey from Blockchain Capital), compared to only 2% in November 2017. There is, then, genuine hope that the DeFi sector will capitalize on this growth, with figures belonging to this sector confident that it will overcome its challenges and make good on its potential.
"I'm very confident about the tremendous ecosystem's growth we could witness in the next coming years," Palayer affirmed. Similarly, Odell said, "While it's still very early, decentralized finance will eventually be the norm if the promises of transparency, openness and access are fulfilled by these solutions.”