Decentralized Lending Market’s Upcoming Crisis

• The decentralized loan market has the potential to grow enormously because of its benefits over traditional lending. Its major advantage is the radical growth of the number of potential creditors.

• Over-collateralization is a major hindrance to both decentralized lending and the DeFi business as a whole. According to a recent Messari survey, since the platform’s launch in the third quarter of this year, liquidity providers on Compound have received the lowest interest rates on their contributions.

• Decentralized finance, if executed properly, has the potential to grow into an important market for corporate financing and a significant segment of the global financial industry.

Over the past few years, Lending has become the fastest-growing sector of DeFi. According to Statista, it accounts for around half of the total volume of DeFi market transactions, to be exact around $40 billion. 

Most experts believe it hasn’t reached the limit yet since the demand for loans is rapidly growing and a large group of potential lenders. Due to its advantages over conventional lending, the decentralized loan market can grow easily.

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Its major benefit is the radical growth of the number of potential creditors. Any cryptocurrency user can become a lender because of DeFi’s open structure if they are open to taking a risk. At the same time, credit scores are relatively low in a decentralized system because of the transparent information regarding the financial position of borrowers than in a transparent financial system.

Decentralized Market Provides Savings To Borrowers

There are significant savings for borrowers offered by the decentralized market since they can meet directly lenders without any middlemen. At the same time, browsers can interact with different pools of lenders pushing them to reduce their appetites.

Since the advent of the Aave and Compound credit protocols, which enable users to offer crypto-assets to use their value as collateral to borrow other assets or for interest, lending and borrowing loans in cryptocurrency has been quite popularized.

However, these platforms require borrowers to over-collateralize their loans. The average collateral when one takes out a loan is 120% of the principal.

Over-collateralization: A Major Hindrance To Decentralized Lending

Over-collateralization is a major barrier to both decentralized lending and the whole DeFi industry. According to a recent Messari study, liquidity providers on Compound received the lowest interest rates on their contributions since the platform’s introduction in the third quarter of this year.

Interest rates are falling mostly as a result of an influx of new lenders looking to profit. And, while the volume of loans is currently growing faster than the quantity of money deposited (57 percent vs 48 percent in the quarter), the difference is decreasing quickly and will soon disappear. To put it another way, the supply of loans will outnumber the demand. This could result in a significant decline in lender income and the collapse of the decentralized lending market.

According to Messari, lenders’ income declined 19 percent in the third quarter of 2021 (from $96 million to $78 million) due to decreasing interest rates on loans. To resist this trend, the DeFi business must learn to make loans with little or no collateral, ideally none at all. This will be a significant step forward in the industry’s progress, allowing for decentralized corporate lending and rescuing DeFi from stagnation.

Impending stagnation in lending

Many businesses are resisting the impending stagnation by offering more tempting terms to customers in terms of collateral volume and loan rates due to a lack of straightforward solutions.

The Liquidity project, which launched in April and gives interest-free loans to borrowers who maintain a minimum collateral ratio of “only” 110 percent, is the most radical example. However, it is still unclear what benefits this invention will bring to creditors.

Other projects gave priority to the security of clients from volatility inherent in the cryptocurrency market and in particular the cryptocurrency lending market. Consequently, now the results with fixed rates are trending.

Bonds Are The Future 

Few projects have come forward to solve the problem of lending without using full collateral.

The Aave platform, Compound Labs’ major competitor, is working on a restricted kind of unsecured lending using a loan delegation mechanism. This strategy transfers the burden of securing collateral to the debt underwriter, who will also be responsible for debt collection, and the end client will obtain a loan with partial or no collateral. The addition of a debt underwriter in the lending process, on the other hand, will clearly increase the cost of borrowing for the borrower while reducing the lender’s profit margin.

DeBond Scheme: Mirrors Traditional Market Processes

Another new project, DeBond, has succeeded to create a scheme that nearly mirrors the traditional market’s established processes. Bonds are used to finance the company’s debt.

This concept requires a potential borrower to enter into a smart contract with their digital assets and specify the terms of the loan, such as the period, amount, interest rate, time, and amount of each loan payment. Furthermore, the user has complete control over all of these characteristics, allowing them to be customized to their particular needs and skills. This smart contract is identical to a regular bond in terms of the borrower’s ability to select between a fixed income and a fluctuating rate.

It doesn’t end here: DeBond’s innovative EIP-3475 algorithm allows the lender to issue derivatives on existing loans, stuffing them into new bonds with various risk and return combinations. DeBond’s platform allows these derivatives to be exchanged on the secondary market.

Debound’s Main Focus Is Bonded Loans

It makes complete sense that Debond’s priority is the mechanism of bonded loans since bonds are the most common form of corporate lending today.

Dollar-denominated bonds will amount to approximately $21 trillion by the end of 2020, accounting for more than 132.5 percent of nominal GDP in the United States. To draw an analogy, the total capitalization of the DeFi market, which is slightly more than $52 billion, maybe calculated using the same ratio. This means that the bond market in this segment should have a volume of $69 billion.

It wouldn’t be a shock if DeFi becomes a significant market for corporate debt and an influential segment of the global financial market if it manages to launch instruments identical to traditional bonds. After all, as Cream Finance correctly pointed out in its presentation, the $70 billion markets for direct bank lending is estimated to top $10 trillion by the end of 2020, this is a drop in the bucket when compared to the total amount of US corporate debt.