The "lending" or. the lending market is one of the fastest growing areas of the DeFi market. According to Statista, this business area now accounts for almost half of the total transaction volume of the DeFi market (around USD 40 billion).
Most experts believe the DeFi market will still grow exponentially due to its advantages over the traditional lending market.
The reason for this is the rapid increase in the number of potential lenders. Due to DeFi's open design, any cryptocurrency user can become a lender if they are willing to take the risk. At the same time, credit risk is lower in a decentralized system, as information about borrowers is in some cases more transparent than in the traditional financial system.
DeFi offers borrowers many advantages
The decentralized market offers borrowers significant financial advantages, as they can contact lenders without the need for third parties. Moreover, borrowers can interact with multiple lenders at the same time, forcing lenders to lower their receivables.
Lending and borrowing in the form of cryptocurrencies has become extremely popular since the advent of the Aave and Compound lending protocols, which allow users to offer cryptoassets for interest or use their current value as collateral to lend other assets. However, analysts criticize that these platforms function more like pawnshops than banks. This is because the platforms are requiring borrowers to over-collateralize their loans. When a loan is taken out, an average of 120% of the loan amount must be collateralized.
The inefficiency of this system is obvious. For example, if you have to put up collateral of 120 euros to get a loan of 100 euros, then the whole thing only makes sense for a very limited number of transactions, such as short-term speculation or leveraged deals. Nevertheless, this model is currently the most popular credit model in the DeFi market. The common procedures for assessing the reliability of borrowers (a credit rating) are namely not used in the decentralized financial system. The reason is simple. Almost all transactions are conducted anonymously, making it simply impossible to create a credit check for a borrower.
Overcollateralization is the biggest hurdle for the DeFi market
It is becoming more apparent by the day that over-collateralization of loans is the biggest obstacle to the advancement of decentralized lending and the DeFi market as a whole. And the crisis is just around the corner. According to a recent report by Messari, in the third quarter of this year, liquidity lenders on Compound received the lowest returns to date on their contributions since the platform was launched.
The decline in interest income is mainly due to the influx of new lenders who also want to make profits. Even though the volume of loans is still growing faster than the amount of money deposited (57% compared to 48% in the current quarter), this gap is closing faster and faster. It is expected to disappear altogether soon. Or, to put it another way, the supply of credit will soon exceed the demand for it. This could lead to a sharp decline in lender revenue and a collapse of the decentralized lending market.
According to Messari, in the third quarter of 2021 alone, lender revenue dropped 19% (from $96 million to $78 million) due to lower lending rates. So the DeFi industry needs to lend with little or ideally no collateral to reverse this trend.
The threat of stagnation in the lending market
Other projects focus on protecting customers from the volatility of the crypto market and the cryptocurrency market. Here's how fixed-rate loans are now trending. In June 2021, Compound Labs announced a product called Compound Treasury. With the new product, users receive a guaranteed fixed interest rate of 4% per year. Compound expects that the product will bring higher US dollar liquidity. This, in turn, has a positive impact on loan rates for borrowers.
Nevertheless, these measures can only delay the crisis in the decentralized credit market. The DeFi market cannot reach the next stage of development without the introduction of decentralized business loans. The problem is that companies will never take loans with full collateralization.
The future belongs to bonds
So how can the previously mentioned problem be solved?? Few projects have met this challenge. Compound Labs' main competitor – the Aave platform – is developing a new form of unsecured lending with a novel credit model. This option shifts the responsibility for securing the loan to the borrower. This is then responsible for collecting the debt. In this case, the end customer receives a loan that is only partially secured or not secured at all. However, the inclusion of the loan underwriter in the lending process clearly increases the cost of loan payments for the borrower and decreases the profit for the lender.
Cream Finance introduced a similar mechanism this year with the Iron Bank loan service. Under-collateralized loans are granted to a limited number of authorized representatives whose reliability has been checked in advance by Cream Finance experts. However, it is still unclear how Cream will compensate liquidity providers if an approved borrower fails to repay the money.
Another new project – DeBond – developed a system based on the established practices of the traditional credit market. The company offers debt financing in the form of "bonds".
In the process, a potential borrower must deposit digital assets in a smart contract and set the parameters of the loan, including the term, amount, interest rate and amount of each loan payment. In addition, the user can select all these parameters individually based on their own needs and capabilities. These smart contracts are similar to a traditional loan in that the borrower can choose the parameters of the loan – fixed or variable interest rate. This smart contract is then placed on an electronic auction platform, where the lender can then buy the bond at attractive conditions. The issuer receives a loan and the lender receives a pledge and his money back. The Smart Contract manages the guarantee claims. But that's not all.
The new EIP-3475 algorithm used by DeBond allows lenders to issue derivatives on outstanding loans and bundle them into new bonds with different combinations of risk and return. These derivatives can be traded on the secondary market on the platform of DeBond. How credit risk is shared between liquidity providers. Compared to the current DeFi lending protocols, this results in a major advantage for the lender. The most important advantage for the borrower is that the collateral does not need to be liquidated if its value falls below the existing threshold of 110-150%.
Will DeFi be one of the most important international financial markets?
Bonds are currently the most important instrument of corporate financing. At the end of 2020, the value of U.S. dollar-based bonds was almost $21 trillion. It is equivalent to more than 132.5% of the nominal GDP of the U.S. For comparison, if we apply the same ratio to the total capitalization of the DeFi market, which is just over $52 billion, then the potential volume of the DeFi bond market is over $50 billion.
If the DeFi market succeeds in creating instruments similar to classic bonds or. Create credit, then the DeFi market could become a significant area for corporate debt and an influential part of the overall global financial market. Cream Finance rightly pointed out during one of its presentations that the $70 billion market for direct bank loans is "a drop in the bucket when compared to the size of all U.S. corporate debt, which will have passed the $10 trillion mark by the end of 2020."