Home > Blog > Are the decentralized lending market facing tough times?

Lending has become one of the most popular and fast-growing areas in the field of decentralized finance. This segment accounts for almost half of the total turnover of the DeFi market – about $40 billion, according to Statista.

Most experts agree: this is not the limit, given the rapid growth in demand for loans and a huge pool of potential lenders. The decentralized lending market can easily arrange exponential growth due to its advantages over the traditional loan system.

The main advantage of DeFi-lending is a sharp expansion in the number of potential lenders. The open architecture of the decentralized finance space allows any owner of cryptocurrencies to become a lender if he is willing to take on the appropriate risks. At the same time, in a decentralized system, such credit risks are less high, since information about the financial situation of borrowers is more transparent compared to traditional financial schemes.

Cash pools for borrowers

The decentralized market has something to offer borrowers. He has large amounts of money, and access to creditors here does not require the participation of intermediaries. In addition, the borrower can simultaneously interact with several lending pools, which creates healthy competition.

The topic of cryptocurrency lending has become extremely popular with the advent of protocols such as Aave and Compound. They allowed users to borrow their crypto assets at a certain percentage or use them themselves as collateral to obtain loans in other assets.

However, as analysts note, the work of these platforms is more like the shops of loan sharks than the work of banks. They require borrowers to provide collateral, the cost of which exceeds the amount of the loan itself. The average cost of collateral is about 120% of the loan amount.

The inefficiency of such a scheme is obvious. Making a deposit of $120 to receive $100 can be justified only in a very limited number of commercial transactions, for example, in short–term speculative transactions or trading using leverage. Meanwhile, such a collateral scheme is the most common in DeFi. This is due to the fact that traditional mechanisms for assessing the reliability of the borrower (credit rating) are not available in the decentralized finance market. The reason for this is also obvious: almost all transactions are carried out anonymously here. This means that it is simply not possible to get a credit history of a particular borrower.

The main enemy of decentralized lending

Every day it becomes more and more obvious that the hyper-collateralization system is the main obstacle to the development of both decentralized lending and the DeFi space as a whole. And the specter of a crisis is already looming in the market. According to the latest data from Messari, in the 3rd quarter of 2021, liquidity providers on Compound received the lowest percentage of funds provided by them in the entire history of the platform.

Interest rates are falling mainly due to the influx of new lenders hoping for a quick profit. Although the growth in the volume of loans still exceeds the growth of funds deposited (57% versus 48% in the reporting quarter), this gap is closing very quickly and may soon be completely eliminated. In other words, the supply of loans may exceed the demand for them. This can cause a sharp drop in lenders’ incomes and the collapse of the entire decentralized lending market.

According to Messari, the reduction in interest rates on loans led to a decrease in the earnings of creditors in the 3rd quarter of 2021 by 19% – from $96 million to $78 million. To reverse this trend, the DeFi market needs to find ways to provide loans with a small collateral, and ideally – without collateral at all. This will be an important breakthrough in the industry, open up new opportunities for decentralized corporate lending and save the DeFi sector from stagnation.

Salvation from stagnation

There are no easy solutions here. Many companies are trying to counter the threat of stagnation by creating more attractive conditions for customers in terms of the size of collateral and loan rates. A striking example in this area is the Liquity project launched last spring, which offered users interest-free loans with a minimum collateral of “only” 110% of the loan amount. Unfortunately, the benefits of this proposal for creditors remained unclear.

There are projects focused on protecting customers from the volatility inherent in cryptocurrencies in general, including the cryptocurrency lending market. As a result, loans that are offered at a fixed interest rate have become a new trend. Last summer, Compound Labs announced the launch of the Compound Treasury product, which guarantees a fixed interest rate of 4% per annum. According to Compound’s expectations, the new product, which gives companies the opportunity to convert US dollars into the USDC stablecoin, was supposed to attract more dollar liquidity to the market and potentially increase the attractiveness of loans for borrowers.

However, such half-measures only delay the onset of the crisis in the decentralized lending market. It is becoming increasingly clear that the DeFi segment will not be able to reach a new level of development without the flourishing of corporate lending. Meanwhile, in order to attract companies, it is necessary to solve the problem of collateral.

The future belongs to bonds

How can you do without full collateral when issuing loans? So far, only a few projects have dared to challenge this problem. Compound Labs’ main competitor, the Aave platform, is working on a limited form of unsecured lending through a loan delegation mechanism. Under this model, the responsibility for collateral is transferred to the loan placement guarantor, who will be responsible for debt collection, and the end customer will receive a loan with incomplete collateral or without it at all. However, the inclusion of a new participant – the guarantor of the loan placement – in the lending process will definitely increase the cost of loans for borrowers and reduce the profit of lenders.

A similar mechanism was launched last year by the Cream Finance project in the form of the Iron Bank lending service (“Iron Bank”, named after the “Game of Thrones”). It offers loans with a collateral size less than the loan amount, but this offer is valid only for a limited number of trusted protocols that have passed a preliminary reliability check by Cream Finance experts and have been whitelisted. However, even here it is unclear how Cream plans to compensate losses to liquidity providers if the approved borrower still does not return the money.

DeBond scheme

Another new project, DeBond, managed to develop a scheme very similar to traditional market practices. The company offers debt financing through bonds.

A potential borrower pledges his digital property in the form of a smart contract and designates all the parameters of the loan, including its term, amount, interest rate and details regarding the stages of debt repayment. The user can select all these parameters individually, based on personal needs and capabilities. Such a smart contract is a complete analogue of a traditional bond, where the borrower can choose between a fixed and a floating rate. Next, the smart contract is put up for an online auction, where the lender can buy this bond if he was attracted by the proposed conditions. As a result, the user receives a loan, and the lender receives a mortgage and a repayment obligation guaranteed by a smart contract.

At the same time, DeBond uses the new EIP-3475 token standard, which allows lenders to issue derivatives on outstanding loans, forming new bonds from them with various combinations of risk and profit parameters. Such derivatives can be traded on the secondary market through the DeBond platform. Accordingly, credit risks are distributed among liquidity providers. This is the main advantage for the lender in comparison with other existing DeFi-lending protocols. Meanwhile, the main advantage for the borrower will be that the collateral will not have to be liquidated if its value falls below the established threshold of 110-150%.

Bond loans

DeBond’s approach is very justified, since at the moment bonds are the main instrument of corporate lending. By the end of 2021, the total value of dollar-denominated bonds was almost $21 trillion, 132.5% higher than the nominal GDP of the United States. If we apply a similar coefficient to the total capitalization of the DeFi market, then at the time of writing it was more than $52 billion. Accordingly, the size of the bond market in this segment could be $69 billion.

If the DeFi industry can launch instruments similar to traditional bonds, it will turn the space of decentralized finance into a significant corporate lending market and make it an influential segment of the global financial market.