DEFI Lending Markets
Summary
Overcollateralization has made on-chain borrowing and lending possible without credit scores or rating agencies
Platforms like Alchemix, Maker, and Liquity have proven robust even in the face of extensive volatility
Undercollateralized lending remains an unresolved issue for DeFi given the lack of legal recourse available to lenders on-chain
Estimated Time: 4 Minutes
Modern finance runs on debt. The systems that facilitate those debt capital markets rely on the structure offered by credit scoring, ratings agencies, and the rule of law. Without a direct connection to these structures, decentralized finance applications have been forced to bootstrap their own alternative systems. With well over $50B in assets deposited into the borrowing and lending applications that have sprung up across DeFi, it appears that this effort is well underway.
DeFi borrowing and lending relies on overcollateralization to compensate for the fact that there is no way to enforce loan repayment purely on-chain. Users of protocols are able to deposit approved collateral types, each of which has a calibrated loan-to-value ratio that then allows them to borrow other assets deposited into the market. The interest rate charged for a given loan is variably determined as a function of the borrowed asset’s pooled supply’s total utilization. This results in a system in which lenders can deposit approved collateral assets, earn yield from users borrowing them, and withdraw their deposits and accrued yield as they see fit. Similarly, a properly collateralized borrower is able to originate and pay down loans without the need for any assessment.
As noted above, depositors in these lending markets are effectively receiving a variable annuity. Not only is the yield determined on a block by block basis as a given asset pool’s utilization fluctuates, but it also accrues to the deposited position in real-time as well. This is possible as the deposit itself is tokenized. In the case of Compound, the user receives a “c” token in return for their deposit (e.g., cETH, cUSDC) that represents a claim on the deposit and any accrued interest. Instead of a token that has a claim on an ever-increasing amount of the deposited asset, Aave issues “a” tokens to depositors, with more being issued as more interest accrues. Both systems are capable of tracking lender positions and enable depositors to further use the tokenized position in other DeFi applications (i.e., use the proof of liquidity, or IOU, as collateral elsewhere in parallel).
Each of these lending markets must decide both which assets should be approved as collateral, and what each of their loan-to-value ratios should be. Should a lending market support a collateral type that later loses all of its value, it then bears the burden of “bad debt.” That is to say, a user who borrowed against the now-worthless collateral has no reason to return the loans they may have taken out against it, thus making it impossible for all depositors of the borrowed asset to wholly withdraw their share of the pool. The communities stewarding these lending markets navigate this risk with collateral assessment frameworks and quantitative analysis.
The largest driver of demand for borrowing in digital asset markets today is user demand for leverage. Collateralized lending platforms allow users to retain their exposure to large cap assets like Bitcoin and Ethereum, while borrowing stablecoins in order to lever up their position, acquire assets they believe will serve as further beta, or arbitrage interest rates between their borrowing costs and yield earned elsewhere in DeFi. Of course, shorting assets is also possible, but the lack of on-chain privacy tends to attract market participants looking to squeeze materially-sized positions. At the moment, the connections necessary for these platforms to finance real world asset purchases are still being built, but users are already able to move their borrowed assets to off-ramps.
Users of these lending markets do bear socialized risks. Given the robust nature of their overcollateralization, however, these markets have regularly weathered wider digital asset market volatility without missing a beat. May 2021 alone saw 30-50% drawdowns in the value collateralized on these platforms; these prove to be some of the most profitable periods for these markets. And so, in practice, what users need to watch for are idiosyncratic sources of risk (i.e., questionable collateral that could lead to bad debt). These can range from illiquid assets that don’t have regular price feeds or reliable secondary markets, to the stablecoins most DeFi developers assume to be worth what they say they are worth.
For obvious reasons, undercollateralized lending remains the holy grail for DeFi today. Progress has been made by projects like Maple Finance, which allow any user to lend into a pool that then gets used to issue a contractually-enforced loan with an approved borrower. It remains to be seen whether truly trust-minimized undercollateralized lending could be achieved; the lack of legal recourse or contractual obligation on-chain has led many to look into the prospect of using on-chain reputation markers to further the concept.
