From its inception, a prime target of decentralized financial (DeFi) systems has been the creation of a sustainable undercollateralized lending mechanism. Several major players in the DeFi lending industry still deploy circular chain systems as a safety net. At present, seasoned traders are the only willing participants to borrow in favor of profitable returns from leverage through crypto exchanges. For DeFi to go truly mainstream, mass adoption of undercollateralized lending is essential.
The Undercollateralized Lending Background
Ongoing efforts to make DeFi lending a viable proposition have been existing since 2017. The main obstacle to its market implementation is figuring out an accurate method to ascertain a borrower’s credibility while providing security to lender deposits.
Renewed efforts for popularizing undercollateralized lending emerged in 2020-21. Interesting propositions and solutions arrived from different sectors of the world. In this article, we aim to analyze the available options and analyze them on the basis of application, advantages, and risks.
Also Read: Financial Inclusion Attainable Through Decentralized Finance: Raj Chowdhury
Available Undercollateralized Lending Systems in 2021
At present, 8 DeFi systems are gaining traction. Lining them one-by-one, we have:
- Flash Loans.
- 3rd Party Risk Assessment.
- Crypto Native Credit Scores.
- Off-chain Credit integration.
- Personal Network Bootstrap.
- Real-world Asset Loans.
- Non-Fungible Token(NFT) as Collateral.
- Loans on Digital Assets.
Flash Loans
Flash loans belong to the class of loans where there are zero risks of default. As the name suggests, a key characteristic of a flash loan is the fact that the loan amount must be credited and debited within the same transaction. Or, the borrowing and loan repayment may occur within the same transaction. While this may sound absurd and non-feasible- flash loans have a market volume exceeding USD 3 billion. More than 80 percent of flash loan applicants are arbitrageurs. They utilize the loan amounts to make the most across decentralized exchanges (DEXs) negating the effects of price fluctuations. While innovative, the product is less likely to be used anywhere outside trade markets- be it crypto, stock, or forex. It is not at all suitable for personal loans, or loans of any other type.
3rd Party Risk Assessment
A favorite among venture capitalists, 3rd Party Risk Assessment follows a unique novel idea. The loan model brings forward a 3rd group other than creditors and debtors to function as a credit assessor. The group in return stakes some of their own funds for validation of the loan that they approved. In case of a default, the assessor’s stake gets slashed first. The working principle owes its roots to the Proof of Stake consensus mechanism of a decentralized blockchain system.
On paper, the chain network credit scoring setup is impressive and features attractive incentives. The main challenge lies in kickstarting the network architecture of efficient credit accessors with appropriate borrower information. The system’s implementation is much more difficult for a retail outfit than trading houses and brokerage players. It will be a practical model once the two objectives are fulfilled- suitable for personal loans, microfinance, or decentralized brokerage.
Crypto Native Credit Scores
The native credit model features characteristics that popularized blockchain implementation- data immutability and longevity. Another key advantage is its cross-platform usability. The basic idea is to build an online identity document that keeps tabs on the user’s activities on the network- after obtaining consent. Activities may include repaying loans, yield staking, crypto trading, involvement in government activity. The data document created is accessible on a cross-platform basis.
A uniform identity across decentralized networks is inevitable in the upcoming future. Present-day setbacks, to a unique crypto credit, score are the option of having an infinite number of virtual identities. The other drawback is the option to switch over to a new wallet in case of loan default. A useful alternative is switching over to zero-knowledge-proof systems. Gaining the customer’s trust and asking for a real-world government-issued ID and attaching it to the virtual wallet in a pseudonymous fashion is the way to go.
Off-Chain Credit Integration
Ideal for personal loans or microfinance, an off-chain credit integration model starts with importing external credit data outside denaturalized finance networks. This lending model may be effective in a short-term scenario- having the required data along with tangible real-life identities. But, it needs to relieve its dependence on traditional financing methods to be truly DeFi.
Personal Network Bootstrap
A personal network model operates on linked associations, invites-only. A potential debtor can apply only after approval from the creditors. The network grows organically, ably guided by the offline trust factor. While being a neat trick, the challenge lies in the scalability of the network without introducing extra offline data for assessment. The rate of default is low even though users can switch wallets on default. Overall, it is a viable DeFi strategy for resolving its scalability.
Real-World Asset Loans
Real-world assets can be mortgaged in a decentralized blockchain network. The asset is represented as a Non-Fungible Token (NFT) which is then used as collateral. The main difference with traditional mortgages lies in the fact that the loan system is decentralized. Experts are placing big hopes on its potential to remove several red tapes of the conventional finance bureaucracy.
NFT as Collateral
NFTs are getting extensively popular among artists and art collectors. In the near future, the valuation of some NFTs will hit the stratosphere like art masterpieces. Due to their crypto-native traits, users can easily liquidate NFTs and settle debts. But, the niche NFT artwork market is susceptible to a fall-back anytime and anywhere. This makes them a bad collateral choice.
Also Read: The Next Big Thing for Retail Investors – NFT
Loans on Digital Assets
Digital Asset Loans became an attractive option for loans in the pandemic-induced economic crisis. An investor can get a loan or even earn attractive interest on their assets. Exchanges offer crypto-backed loans in terms similar to a bank car loan or mortgage. They keep the digital assets as loan collateral. A user can also lend their crypto token through the exchange and yield hefty returns. Digital loan assets are steadily gaining traction and are a popular choice for leverage trading.
Conclusion
DeFi undercollateralized lending as a segment is regularly witnessing new innovations and implementation. As a major hindrance to universal DeFi, it is safe to say that projects which overcome existing challenges will build the DeFi framework for the future.
As a global enterprise spread across 5 continents, PayBito specializes in banking, crypto trading, and DeFi offers a novel crypto banking solution using bitcoins as loan collateral. Some of its other ventures include exchange solutions for real estate, gaming, and reputation.
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