Decentralized Finance, or Defi, has taken the blockchain world by storm. According to DeFi Pulse, at the time of writing approximately $13.73 billion are currently locked within defi protocols. But when the dust of governance tokens, yield farming, flash loans and the like clears, what do we have left? The basis for open finance, borderless financial ecosystems that allow for unfettered access to capital and services, enabling entities of all shapes and sizes to seamlessly connect with one another. We are witnessing the first blocks being laid on the journey to a more democratic financial world.
Defi looks to combat the world of traditional financial institutions. These age old behemoths are the pillars of modern day commerce, and reliance on them (I won’t say trust because who trusts banks or governments anymore), will not fade quickly. Historically, intermediaries have assumed a majority of the counterparty risk. They’ve also assumed responsibility for a lot of the leg work – attracting borrowers and lenders, bringing together capital, setting interest rates and terms, following up on delinquency, insurance for lenders if borrowers fall through, asset security etc. Financial institutions are a function of specialization, the basis for modern economies. In return for their assumption of these responsibilities, they take a fee. However, with advancements in blockchain, what has been found is that MANY of these operations can be codified and enacted autonomously, making for a much more efficient, democratic system.
The current model for decentralized finance has accommodated for trustlessness and volatility through overcollateralization. When engaging with open blockchain protocols, the entities you interact with could be anyone, anywhere in the world. You know very little about them with the exception of maybe their public address – you could take a look at their transaction history but that’s about it. Because we have very limited knowledge about creditworthiness, overcollateralization is required… which makes sense, if someone up and leaves, it is guaranteed that there is enough funds within the protocol to make the lenders whole. However, this severely limits the effective use of capital. How so?
Banks take the idle capital of lenders, and distribute it to borrowers in need of capital – the borrowers pay interest in exchange for this service, and lenders receive interest to compensate them. Simple enough. The amazing part about this is that it puts capital to use that otherwise would just sit there – the more things we have working, the more productive we are. And that’s where defi has failed thus far. At the time of writing, if you take a look at the Compound Protocol, you’ll see $3 154 420 723.54 in assets earning interest, compared to $1 645 620 576.63 being borrowed – leaving $1 508 800 146.91 sitting on the table, not doing anything. Despite how inefficient this is… it makes sense, you have no idea who’s borrowing your money, so over collateralization is necessary to maintain security, otherwise we’d have people running off with funds left, right and center.
This leads to a second issue. Generally, those in need of funds don’t have them… especially within the developing world where this technology has the potential to make the most difference. Although users can access decentralized applications from anywhere with an internet connection, there are still apparent barriers that limit their use, namely, the exorbitant capital requirements. That being said, increasing the amount of information available regarding creditworthiness can make for more dynamic lending environments, where less capital can be leveraged to do more. Now, how do we go about increasing available information regarding blockchain users?
For an increase in information to be useful, we must first be able to consider that information. Oracles are the first solution, and we have Chainlink leading the charge in this department. At Fluidity 2019, Sergey Nazarov, Cofounder & CEO of Chainlink, delivered a brilliant presentation titled, “Connecting Blockchain and the Real World.” In it, he discusses the limited utility of blockchain and smart contracts without real world data, and the importance of contracts being able to react to real world events. Nazarov estimates that the lack of real world data has meant that we do not have access to approximately 80% of the possible contracts that could be generated within decentralized finance. Oracles increase the inputs that blockchain protocols can consider, allowing for more dynamic smart contracts.
Good Credit Rating? Reduced Collateral Requirements
Teller Finance has integrated Chainlink data feeds in order to offer undercollateralized crypto loans. Leveraging real-world credit history, Teller is able to calculate annual interest rates (APR) based on market conditions and consumer credit risk, thus reducing, and in some cases, potentially eliminating, the need for collateral.
Aave, a DeFi money market that allows users to earn interest on cryptocurrency and borrow against it, introduced credit delegation in early July. This service allows someone with a lot of collateral deposited on Aave and no desire to borrow against it to delegate their credit line to a third party they trust.
Aave, previously ETHLend, is considered among the top defi protocols today. In July, they introduced an innovative new feature called “credit delegation,” where depositors who didn’t intend on borrowing against their capital could allow other users to do so, thus creating a situation where lenders can be compensated for capital they make available to borrowers, and allowing capital to be efficiently used. Those that issue a credit line are able to set specific requirements of the borrower via OpenLaw Contracts, where they can turn to courts or arbitration in case of default. Aave has seen limited use of this function, with only one uncollateralized loan being issued for Deversifi, an exchange. However, credit delegation opens the doors for more efficient credit markets on-chain.
The XDB Foundation, the organization that supports development of the DigitalBits Project, recently presented at the World Stablecoin Summit – sharing their vision for Branded Stablecoins. The team envisions branded stablecoins surpassing current iterations of stablecoins, moving beyond combining blockchain technology and stability, and actually enhancing relationships between on-chain parties – consumers, merchants, brands, payment processors etc. As far as our conversation on credit issuance is concerned though, the team expanded on the provision of financial services using branded stablecoins, where blockchain technology could be used to account for consumer data currently not considered.
“There are approximately 1.7 billion adults worldwide that are unbanked. Many lack sufficient capital to initiate a bank account. These same people however, engage with brands on a consistent basis, resulting in millions of actions worldwide currently not considered by the traditional financial sector. These same actions could be the basis by which they generate a financial profile, credit history, and begin to interact with services they were previously locked out of. This is where branded stablecoins can truly make a difference.” – Rajiv Naidoo, XDB Foundation
In recent news, Stably, the Seattle-based fintech firm responsible for USDS, partnered with the XDB Foundation, bringing their Stablecoin-as-a-Service to the DigitalBits ecosystem. This white label solution streamlines the issuance of assets on-chain, potentially bringing a robust set of new assets to defi applications.
The concept of Chama’s originated in Kenya, as a platform to distribute micro-insurance products. Translated from Kiswahili, it means “group” or “body,” and provides an informal micro-saving group that allows people to pool and invest their savings together. Individuals gain access to larger amounts of capital than they would on their own, and are incentivized to repay their loans via social pressure. Interest is paid on issued loans, increasing the total capital available within the Chama. Chamas have been wildly successful, with over 300 000 operating within Kenya today, commanding approximately $3 billion USD in assets.
So what do Chamas have to do with blockchain?
Akropolis, a defi protocol building on Polkadot, looks to introduce Chamas in a decentralized manner, utilizing the benefits of social groups to increase access to financial services while reducing capital requirements.
Members can get an undercollateralized loan, by requesting it from the pool. The borrower must provide 50% of the collateral themselves. The remaining 50%, must be staked by other DAO members. Members use on-chain social reputation, along with identity metrics, and 3rd party credit scoring to assess risk of the borrower.
More Information, Reduced Barriers, Increased Access
Up until now, decentralized finance has revolved around ONE of the 5 C’s of credit, collateral. This has allowed for secure, decentralized lending environments that are relatively resilient to delinquent payments and volatility. Black Swan events, such as the one that took place in March 2020, are still able to throw these systems for a loop, the MakerDAO Foundation had a field day dealing with the sudden drop in the value of Ether, but for the most part, excess collateral means that lenders are protected.
However, what we have seen should be viewed as proof-of-concept as opposed to a final product – as it stands today’s credit markets cannot be supported by defi solutions. Protocols must be able to consider all 4 C’s of credit – character, capacity, collateral, capital and conditions – the integration of oracle services can help with this. From there, protocols must build in features that consider these new data sets. Slowly but surely, these decentralized systems will be able to consider entities based on a slew of information, and issue financial services accordingly. We are a long way off, but the right steps are being taken. Decentralized Finance will one day truly… decentralize finance.