The DeFi Credit Market in 2022 and Beyond
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The mood in the crypto industry has been a bit too negative recently.
Yes, the total value locked in DeFi is down from $300 billion to $67 billion. But even that is still a ~300% increase from where DeFi was at the start of 2021. The situation really isn't as bad as the doomers make it sound — and the next narratives are already on their way.
One is the Ethereum merge, but in its slipstream, something much more exciting is brewing: the emergence of a true credit market in DeFi.
Credit markets, of course, already exist, although they do not resemble those in the traditional financial sector. This article will look at:
What type of lending already exists in DeFi
What undercollateralized lending implies and why it will be the "next big thing"
How CreditX contributes to building a true credit market in DeFi
The DeFi Credit Market in 2022
There are currently only two "real" options for lending and borrowing money in DeFi — overcollateralized lending and NFT lending.
Overcollateralized lending
This is the essence of DeFi and, in one way or another, its only real use case beyond speculation (i.e., beyond what decentralized exchanges and perp exchanges do). You put your hard-earned coins and tokens down as collateral and borrow new coins against them in the hope of growing your stack.
Overcollateralized lending comes in different flavours, but it always comes down to a loan-to-value ratio between 50% and 80%, depending on the protocol and the collateral you borrow. It is a hands-off way of putting (a part of) your money to work since you can deploy the loaned capital as you wish. Moreover, managing the loan itself is simple — most protocols provide a comprehensive dashboard.
The good and the bad of overcollateralized lending
Although its mechanics are fairly simple and obvious, overcollateralized loans were a big thing when they hit DeFi. In fact, they are DeFi since only a bit more than two years ago, most of the current landscape didn't exist. The advantages are obvious:
You can borrow many different assets against your collateral.
In 2022, these loans are available on almost every chain.
You can leverage your otherwise idle capital.
Trivial as it may seem to finance veterans, that was enough to suck in most of the TVL now deployed in DeFi.
Still, that doesn't hide their many shortcomings:
They're essentially just another facilitator of speculation.
They're not capital-efficient.
They require capital to be useful in the first place (i.e., make the rich richer).
If you offered the common man on the street the option to borrow $5K against his $10K collateral, you'd only earn confused looks. Overcollateralized lending is an important evolution, but it is only that — an evolution. Be it Aave, Compound, Raydium on Solana, or one of the countless other protocols. By definition, none of them can bring DeFi to the masses.
NFT-collateralized lending
The last innovation in DeFi, which is still in its initial growth phase, is using NFTs as collateral to borrow against. These loans are the crypto equivalent of collateralizing a valuable piece of art in the real world — only that you don't rely on intermediaries but on code.
There are two types of NFT loans: peer-to-peer and peer-to-pool. Both allow owners of valuable NFTs (think CryptoPunks and Bored Apes) to put up their NFT as collateral. With peer-to-peer loans, loaners and borrowers define the terms of the loan, such as loan-to-value ratio, loan duration, and liquidation terms, on an individual basis. With peer-to-pool loans, the borrower collateralizes their NFT at its floor price and borrows from a liquidity pool.
Both models have upsides and downsides but are essentially a subset of overcollateralized lending (just with another type of collateral). Due to the illiquid nature of the collateral, NFT loans have significantly lower loan-to-value ratios, typically below 40%. Peer-to-peer loans allow these to be defined individually.
The good and the bad of NFT-collateralized lending
Collateralizing real-world art is messy at best and impossible at worst. Art is notoriously illiquid, difficult to value, and requires a trusted counterparty to do business with. NFT loans are a nascent but interesting digital evolution of this analogue market. They allow the financialization of digital art and validate the most valuable NFT collections as such (since only sufficiently sought-after collections are accepted as collateral).
However, NFT loans are even more exclusive and speculative. Someone with a Bored Ape worth 60ETH+ is neither starved for cash nor would they put down their Ape to receive a student loan. Although this market can and will grow in the future, it doesn't solve any of DeFi's inherent problems — exclusivity, speculation-oriented, fueling the rich-poor divide.
Undercollateralized lending
So, what's the fuss with undercollateralized lending? Why is everyone getting so excited about it, and, most importantly, why have all attempts to create undercollateralized loans in DeFi failed thus far?
A true DeFi credit market essentially recreates what exists in real financial markets but on crypto payment rails. Imagine not having to go to a bank to get approved for a loan but logging onto a DeFi protocol and receiving a loan for online or offline use there. Or being able to loan your collateral via DeFi for real-world use cases. That would be decentralized finance in the true sense of the word — handling your finances not with one centralized counterparty (a bank) but with one or several decentralized ones (DeFi protocols).
But how do we do this without relying on borrowers already having sufficient capital?
That's been the elusive sorcerer's stone for DeFi thus far. However, with traditional credit markets worth $11 trillion globally, there's plenty of incentive to find solutions. And DeFi protocols have been working in the shadows on those:
Decentralized credit scores: these recreate the credit scores you know from banks. There is no consensus on a best practice yet, but protocols are working on tying DeFi credit scores to wallets or soulbound tokens (i.e., a token representing a verified human).
Crypto loans to non-crypto businesses: an evolution from peer-to-peer loan marketplaces of old. Instead of relying on a company to escrow money and check the borrower's creditworthiness, these protocols crowdsource the work. Approved borrowers access liquidity pools and use the capital for non-crypto-related use cases. Successful examples include loans to emerging markets like India, Brazil, and Kenya.
Zero-coupon bonds with limited collateral: these are DeFi's version of corporate bonds. DAOs can put down limited collateral and get approved for loans based on a combination of credit score, reputation, and collateral value.
The idea is clear: creating a more efficient and transparent version of the current financial system and simultaneously forcing the established system to compete with new models. Undercollateralized loans establish a real-world use case for Defi that goes beyond speculation. They also create greater interconnectedness between decentralized and centralized finance.
Contrary to what DeFi-fearing regulators may want you to believe, this is a good thing: if more on-chain capital can be used for non-speculative purposes in the real economy, this creates credit and eventually economic growth.
When will this happen and where does CreditX come in?
All three use cases (credit scores, crypto-to-real-world loans, zero coupon bonds) will eventually follow the DeFi money lego logic and become intertwined. However, CreditX will focus on zero-coupon bonds.
CreditX offers a permissionless credit issuance platform to borrow capital purely based on on-chain creditworthiness. CreditX tokenizes each loan and thus creates a zero-coupon bond market, allowing lenders to raise capital with or without collateral posted. It also offers a secondary market to trade said zero-coupon bonds.
In plain English, CreditX is the on-chain version of a corporate bond market, built in a straightforward way, without different fixed yield tokens.
Undercollateralized lending is just getting started. Expect this market to surge over the next years with the adoption of zero-knowledge proofs for credit score-checking. But CreditX MVP is already in the works and will integrate state-of-the-art on-chain credit scoring with the first iteration of permissionless undercollateralized loans. The building blocks for the next wave of DeFi innovation are being laid down and will bear fruit sooner than many can anticipate.
Cheers, till next time!
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