DeFi protocols compete with the traditional financial services sector. It is a fast growing industry in the cryptocurrency space based on DApps (Decentralized Applications) that use intelligent contract execution mainly on the Ethereum blockchain. The TVL (Total Value Locked) in DeFi is valued at $ 82.18 billion as of late September 2021, powered by lending and decentralized exchanges (DEX). A lot of capital flows into the liquidity provided by a financial instrument that opens up new financing options.
Lending has particularly great potential for DeFi (valued at $ 40.28 billion) made available through lending protocols like Aave, Maker DAO, and Compound Finance. It’s also offered as a service by fintech companies like Celsius, BlockFi, and Nexo. Some of these protocols offer fair rates on borrowing that can be converted from crypto to fiat. Users can also deposit funds into an interest bearing account for credit purposes.
One of the main characteristics of DeFi lending is that it has different requirements compared to traditional creditors. Lending lenders can fund individual and business needs, but the requirements are many. One of the most important requirements from lenders is that the user must have a good credit rating (FICO score of 640 and above in the US). The higher your credit rating, the more capital is available for borrowing. DeFi does not have these strict requirements to transmit or collect personally identifiable information (PII) from its users. A user can borrow money quickly (no questions asked) by using cryptocurrency as collateral.
When lending to borrowers, banks and other creditors charge a customary interest rate based on their credit analysis. A borrower can use some form of collateral to secure a loan. Security can be the person’s car or house, which in itself is the valuation of their personal wealth. Without collateral or an unsecured loan, the borrower often receives a higher interest rate and limited funds can be raised. The debt owed is then added to the interest, which is compounded depending on the conditions.
For a simple $ 30,000 loan with no collateral, let’s say the interest amount payable is 36% of the principal:
“Acme Bank” -> 30,000 + 0.36 (30,000) = 40,800
Interest Owed = 10,800
The lender grants an installment payment that can be made monthly, quarterly, semi-annually or depending on the loan terms agreed between the two parties. The higher the creditworthiness of a borrower, the lower the amount of payments.
If a borrower is approved at 36% interest (which means low credit), the borrowed $ 30,000 can be paid in a monthly installment of $ 1,374.11 per month for a period of 36 months (3 years). Creditors offer a much better interest rate to those with excellent credit scores (800+ and above). For the same amount borrowed, borrowers with excellent creditworthiness can pay at a monthly rate of 10%, which equates to $ 968.02 per month.
This is just a theoretical example, but it is based on how lenders provide capital to borrow. It requires the approval of the lender using criteria based on financial rules and regulations.
Using an example based on Maker DAO, a borrower only needs to provide his digital asset as collateral. There is no KYC (Know Your Customer) or third party approval. Once the collateral has been provided, users can take out loans using what is known as a CDP (collateralized debt position). The debt payment is the amount value of the CDP quota, which can be up to 150% (e.g. USD 20,000 for blocked ETH worth USD 30,000). The overcollateralisation is intended to secure a loan repayment by the borrower.
In Defi, the deposited securities do not determine the amount that a user can borrow. How much a user wants to borrow against their collateral depends on the LTV (loan-to-value) ratio. In Maker DAO, this is determined by the CDP. The more valuable the digital asset, the higher the risk if its value falls. Borrowers need to ensure that they can repay the loan or increase their collateral value to settle the liquidation as per the protocol.
The loan log gives out the amount you can borrow in the form of a stablecoin token. In Maker DAO that would be the DAI stablecoin. All you have to do is repay the amount to DAI (linked 1: 1 to a fiat currency, valued in USD) that can be released based on the ratio. There is also no actual term as borrowers can repay at any time to reclaim their collateral.
In this example, let’s say a user wants to borrow $ 30,000 from Maker DAO. The borrower would have to provide collateral with a CDP ratio of 150%.
“Manufacturer” -> 30,000 * 1.5 = 45,000.00
The collateral for depositing into a CDP must be worth $ 45,000. This can be in the form of ETH (Ether) which is the most popular form of collateral used to generate DAI. This is then blocked in a CDP smart contract in the MakerDAO network.
For the amount of 45,000 USD, the amount of 30,000 USD is issued in DAI. The borrower’s expectation to repay the loan is good faith, but remember that there is a security that is locked by the loan log.
When repaying the loan, Maker charges a so-called stability fee. If the fee is 6% then:
Interest owed = 30,000 * 0.06 = 1,800
If the borrower cannot repay the loan or decides to default, his collateral will be realized. With some DeFi protocols, the collateral can be liquidated if the LTV ratio exceeds a certain threshold. This can happen when the value of the collateral on deposit decreases based on market value.
From both examples, if the borrower borrows an amount of $ 30,000, we assume that the borrower does not have good credit. When you compare the difference, you pay less interest on the same amount of money borrowed from a DeFi loan record. You have to pay “Acme Bank” 10,800 US dollars in interest, while you pay “Maker” only 1,800 US dollars. The interest rate differential is what a DeFi borrower saves, which is $ 9,000.00.
A person who borrows from the bank will owe $ 9,000 more than if they borrowed from a “maker”.
Ratio = 1/6
For every dollar you pay to Maker, you pay $ 6 more to the bank. Banks will earn $ 10,800 from interest payments, while the “Maker” will earn $ 1,800 from accrued interest on the stability fee. It seems that banks are taking more money out of interest rates because of their policy calculations.
This is just an example, not an actual proportional comparison. What you leave as security in a bank is not exactly what you deposit in cryptocurrency. This underscores how decentralized lending can save more than from a traditional financial institution.
If we look at face value, it seems that traditional finance lenders (including banks) are simply taking too much money from borrowers. There is actually a reason why they do this. Lenders like banks collect more money because of their organization. The profits from the income from loans go to board members and shareholders. Large financial institutions in the private sector have a profit motive, which is why interest rates are higher.
DeFi is a decentralized financial protocol. It is not an actual company or institution with board members and shareholders. Instead you have token holders (e.g. MKR tokens for Maker DAO). It serves as a platform for facilitating transactions such as lending. The token holders, who are a decentralized community, benefit from the fees that are charged on loan repayment. Anyone can be a token holder on the platform by exchanging DAI for MKR. As an MKR holder, a user is like a board member in that the token grants them voting rights to determine the development and guidelines of the protocol.
The reason for holding MKR is some form of incentive. While banks have a small group of individuals who make up the board that dictates the guidelines, MKR owners are a large community that participates in digital governance. Hence, DeFi protocols are based on a form of decentralized digital democracy in which there is a larger group voting politics on a majority basis, while banks are more like a centralized authority with a few people at the forefront of decisions Organization to be taken.
When a borrower is having difficulty finding a loan from traditional lenders, DeFi is an option. No documents are required or questions asked in DeFi. However, it does require collateral in order to obtain a loan from a DeFi protocol. The borrower would need to have a digital asset such as ETH or Bitcoin (BTC) in order to enter into a smart contract with an LTV ratio. Otherwise, a borrower has the option of paying higher interest rates on an unsecured loan from traditional lenders.
DeFi lending protocols offer more opportunities for financial inclusion. This property makes it an attractive alternative to traditional financial instruments. Borrowers do not need approval based on submitted documents or credit scores to obtain loans. DeFi only requires collateral in the form of digital assets (i.e. cryptocurrency) and everything is automated through smart contracts. There are no credit counselors or agents in DeFi, so borrowers must independently manage their own loans. If you have the collateral, DeFi can be an easier way to get a loan as it doesn’t require third party approval.
An important consideration is to ensure that the value of the collateral does not drop below a certain level or is automatically liquidated. That is the risk associated with DeFi. It gets riskier the higher the LTV ratio when borrowing against the digital asset. If the collateral value is above the threshold, the borrower does not have to make any payment. If the threshold is reached, borrowers must either increase their collateral or repay the loan if they want to reclaim it.
Innovative financial products such as those used in DeFi will compete with traditional financial institutions. This can lead to a more competitive market as fintech and traditional lenders enter the space to offer similar products. This will benefit users even more as more options are available. Whether one is better than the other cannot be conclusively answered, but it all depends on the requirements of the borrower. DeFi is just an alternative to what’s available.
The most important finding here is whether there will be any regulation of the DeFi space. It will all depend on how regulators and agencies like the US SEC (Securities and Exchange Commission) or the FATF (Financial Action Task Force) view DeFi lending as it uses cryptocurrency. Perhaps they see its potential as positive for the economy from an overall micro perspective, so this could contribute to further growth.