Lending on the Blockchain

“Investing for income in today’s markets is like slogging across the Sahara looking for a cold drink,” wrote WSJ columnist Jason Zweig earlier this year. He’s not far from the mark: in some European economies, every borrowers’ wildest dreams have come true, and the bank now pays them interest on their mortgages. “We wanted to move out of the city center, but it is hard to leave such a good mortgage deal behind,” said one Lisbon dweller, who receives monthly interest payments of ~$45 from her bank. Of course, there’s no free lunch, and for every rejoicing mortgage holder there’s a mournful saver forced to pay fees just to retain a bank account balance. Where are all the virtuous savers fleeing? To the unlikely shores of decentralized finance (DeFi), one of the last safe havens for an aspiring coupon clipper in the 21st century. Most people don’t associate cryptocurrency with an image of the inveterate saver, and yet, thanks to the liquidity surge spawned by DeFi Summer of 2020, both borrower and lender alike have a chance to reap new yields. This week, as we all decompress from the Elon Saga and the subsequent crypto market turmoil, we dive into the brave new world of crypto lending: its risks, its promises, and its rewards.

What is DeFi? DeFi is an Ethereum-based marketplace of decentralized applications (Dapps) that seeks to build a better financial landscape by eliminating some of the inefficiencies and limitations of off-chain finance. While any kind of organization can be built on the blockchain (we discussed the importance of DAOs here), finance has emerged as the most natural product fit thanks to its disproportional dependance on intermediaries. Each Dapp is run by a smart contract protocol: a set of rules that establishes a predictable environment. Many crypto theorists think of blockchain protocols as the 21st century’s latest and greatest iteration of human organizational schemes: we evolved from Feudalism, to Religion, to the State, to Democracy, to the Internet, to … Crypto. Or so they evangelize. Just as the Ten Commandments act as a protocol for Christianity (if adultery, then hell; if faithful, then heaven), and the Constitution acts as a protocol for the United States (if accused, then trial; if home, then safe), so too does Ethereum act as a protocol for crypto-economics. Some commentators have complained that DeFi simply copied everything from traditional finance and plopped it onto the blockchain. “In its early days, crypto was a brand-new financial system, unsullied by the old evils of central banking, leverage, regulation, etc.,” wrote Matt Levine. “Eventually people realized that some of those things were good and started reinventing them.” Others enjoy the newfound freedom of an amnesic community: “All the fun that used to be had 30 years ago in the commodity markets and is no longer fun — that fun is now in crypto,” said Trey Griggs, CEO at GSR Markets in Houston. Regardless, crypto never claimed originality as its intended goal: its whole advantage is that it sits on a permissionless, trustless blockchain that allows code — rather than intermediaries — to store money. “Traditional finance exhibits layers of fat and inefficiency that ultimately remove value from the average consumer,” writes Campbell Harvey, a finance professor at Duke University who specializes in blockchain technology. “The contractual efficiency of DeFi brings all of this value back.” What is some of the fat? Credit card transaction fees, remittances, and stringent regulations (think KYC and AML policies). Crypto’s mainstream appeal became apparent during DeFi Summer, when Total Value Locked (TVL), the amount of value available for lending and other money markets, climbed from $800 million in April 2020 to $10 billion in September 2020, an increase of 10x. But DeFi Summer was just the beginning of the intoxicating bull market: TVL reached an all-time high of nearly $88 billion on May 11th, 2021 and now stands at $67 billion, following the Elon tantrums). Lending on the Blockchain The three biggest lending protocols are Aave ($18 billion TVL), Compound ($14 billion TVL) and MakerDAO ($4 billion TVL). How do lenders incentivize repayment from a person with no name, no credit score, and no physical address? They only accept over-collateralized loans. This form of secured lending is nothing new: it has existed since Medieval Venice, when the Black Plague inspired new forms of financial innovation. Decentralized blockchain loans are user-generated, non-custodial, and drawn from a peer-to-contract model. This allows the user to borrow or deposit into a pool of funds, exiting at any time with no penalty. Interest rates are variable and calculated algorithmically in real-time. Any pool with high liquidity will be relatively cheap to borrow from, and vice versa. Interest rates fluctuate every block (~15 minutes) based on the supply and demand from the money market. The Annual Percentage Yield (APY) on stablecoins has fluctuated from 2% to 20% in the last year. (Aave currently offers ~8.5% APY on USDC deposits). How to Avoid Defaults The lending protocol simultaneously acts as debt collector, liquidator, and real-time interest rate calculator. There is very little chance of default on blockchain loans because each is typically backed by 150% — 200% collateral (the riskier the asset, the higher the collateral factor). Unfortunately, there are no margin calls in crypto: dipping below the collateral factor causes instant liquidation. “In the Maker system … if your collateral ratio ever drops below 150%, a “Watcher” will step in, and *POOF* — your collateral is liquidated at a 13% penalty to repay your loan,” noted one crypto entrepreneur. The high collateral factor provides some buffer zone, but a prudent borrower never draws the full loan amount in case of sudden price drops (as occurred this week with ETH and BTC — over 775,000 traders had their accounts liquidated, equal to $8.5 billion worth of crypto). Should a liquidation occur, the original owner receives the value of the leftover collateral minus the debt, interest rate, and liquidation penalty. Liquidations aside, what is the appeal of pledging 200% collateral just so you can borrow half of that amount in fiat or crypto? It turns out, there are many use cases. Just as a homeowner might draw on a home equity line of credit for some unexpected expense, blockchain loans offer newfound liquidity to users who own a crypto asset but don’t want to sell it outright or incur a taxable event. “Prior to this, holding a digital currency was no different than holding a bar of gold in a safe,” said Jason Urbam, CEO at Drawbridge Lending. “There’s no utility in that. By lending it out, they can unleash the value of that asset.” The user can also use borrowed assets to leverage long or short positions, with competitive pooled rates and virtually no approval process. If an investor is bearish on the price of Ether (ETH), they can simply deposit a stablecoin — coins pegged to an underlying asset, such as the US dollar — as collateral to borrow ETH, and sell it for more of the same stablecoin. Yield Farming & Flash Loans DeFi’s real innovation is in its relationship to users. It took the strategy of Web 2.0 — gain new users with free apps — one step further: pay users to join your network. Perhaps the biggest impetus for DeFi Summer was Compound’s brilliant decision to mint its own governance token (COMP). Users who drove liquidity to Compound — whether by lending or borrowing on the protocol — were rewarded with COMP tokens, earning a yield on the tokens for their efforts. “This kind of activity is not a Ponzi,” said Hasu, a prominent crypto researcher and writer. “What’s actually happening is that people are getting a percent of the network by participating in it. It comes back to the idea of users owning the network. And how do users come to own the network? Well, they must be given tokens as the protocol grows. It’s kind of like an early user reward system for helping bootstrap the network effect.” The extra incentives dramatically impacted APYs on different tokens. This led to the development of yield farming, the so-called “rocket fuel” of DeFi, as users frenetically switched between borrowing and lending to achieve the best yield possible. Over the course of just a year, yield farming caused a parabolic ascent in liquidity — TVL grew from $1 billion to nearly $85 billion. Aave focuses more on product differentiation, and is the first lender to offer short-term fixed interest rates as well as flash loans. To date, flash loans are the only form of uncollaterized loans available on the blockchain. The caveat is, they have to be borrowed and repayed within the same blockchain transaction. The funds are designed so that they are automatically returned at the end of each block. While such ephemeral transactions may not be useful to most parties, flash loans allow advanced users to exploit arbitrage opportunities or refinance loans without pledging collateral. New Lending Opportunities with Ethereum 2.0 Despite their early success, current crypto lending models are woefully capital inefficient. The existing market is only ideal for thrill-seeking crypto-natives or capital rich whales. As one crypto reformer puts it: “The world is not made of rich Compound whales. Under-collateralization is everywhere.” Fortunately, Ethereum 2.0 — a major revamp to the existing architecture — is expected to be released sometime in the next year. This would lower scaling risk (Ethereum can currently handle less than 0.1% of Visa’s traffic), reduce gas fees, reduce energy output, and allow for new use cases such as smaller volume transactions. Unsecured, credit-based lending is also being explored (although, these loans would have to be very thoughtfully constructed: the evasion of credit scores is one of blockchain’s most touted virtues), and cash flow lending would be a natural outgrowth as more revenues move on chain. In the meantime, if Cathie Wood isn’t worried about crypto, neither are we. Stay safe this weekend and #HODL 💎 🙌 . About Colbeck: Colbeck is a strategic lender that partners with companies during periods of transition, providing creative capital solutions to meet their evolving needs. You can reach the team at inquiries@colbeck.com.

Full story: https://medium.com/limited-liabilities-by-colbeck/lending-on-the-blockchain-8a933ff7b72d