Lending has emerged as one of the most popular and practical use cases within the industry of blockchain-powered financial products known as decentralized finance (DeFi). The ability to borrow value-backed assets without an intermediary, you say?
That is part of the deal, but there is more to it.
So what is decentralized lending, how is it different from traditional lending, and what is the outlook for this relatively burgeoning category of financial products?
What is decentralized lending?
The mechanisms of decentralized lending are fundamentally similar to traditional lending:
- One person lends assets in exchange for interest payments (and in some cases extra rewards)
- Another person borrows assets and pays interest payments for the right to immediate financing
However, instead of dollars, decentralized lending relies on cryptocurrency as a medium of exchange. There are several platforms on which users can enter into credit-related transactions (more on that later).
Smart contracts are the mechanisms that enable decentralized lending. These contracts are protocols that execute themselves and can have different functions (for example, dividing interest payments, setting variable interest rates, and implementing other terms of a loan).
These contracts are unbiased, in themselves incapable of nefarious motives or bad faith tactics, and allow all participants in a loan transaction to see exactly where they stand at any given time. In other words, they are not banks.
What are the benefits of decentralized lending?
Investments in decentralized credit platforms have definitely skyrocketed in 2020, but why?
Widespread mistrust of traditional financial institutions can play a big role in the optimization of DeFi lending. CNBC explains how millennials in particular have shown their suspicion of traditional banks and cites The Great Recession as one of the reasons for skepticism.
With banks needing to keep 0% of customer deposits on hand, per the Fedwillingness to try non-traditional financial products seems to be rampant. Consider the suggested benefits of decentralized lending:
- Rather than having a financial institution with a spotty track record involved in your financial transaction, DeFi Lending offers a smart contract to execute the transaction
- For lenders, interest rates on certain DeFi lending platforms can far exceed the returns of other centralized investment alternatives
- Rather than a large, anonymous bank reaping the benefits of lending, DeFi lending offers a peer-to-peer experience
- Lower barriers to obtaining a loan than are present in traditional lending processes (if you have the necessary crypto collateral you can generally secure the loan you are looking for)
From an investor’s point of view, borrowing cryptocurrency can avoid having to sell existing bets in crypto, which can come with fees and opportunity costs. Just based on the massive capital injection into DeFi credit platforms in recent months, it is clear that the benefits of decentralized lending have a legitimate appeal.
What is the current state of decentralized lending?
DeFi Pulse’s DeFi listing sheds light on 12 separate decentralized lending platforms. The amount of digital assets stuck in decentralized lending platforms is significant, with the leading platforms Compound, Maker and Aave jointly responsible for significantly more than $ 3 billion in digital assets. DeFi Pulse maintains a current account of the “locked” assets of the entire DeFi credit industry.
$ 3 billion and change is remarkable, and becomes even more striking when you consider that the DeFi credit markets have seen a massive injection of capital in 2020. Yet decentralized lending and borrowing products seem modest compared to traditional lending. Outstanding consumer debt issued from centralized sources is over $ 13 trillion.
The significant capital gap between DeFi credit platforms and traditional credit institutions is informative, but says little about the long-term viability of DeFi lending. Established financial institutions’ lead in decentralized alternatives (2016 spawned the first DeFi lending platforms) should be considered when making comparisons.
DeFi credit platforms should be judged on their own merits, rather than in comparison to centralized alternatives. This lens makes decentralized lending a product that investors are very optimistic about.
Some have noted DeFi lending transition from ‘niche’ to ‘mainstream’ (injecting billions into capital in a matter of months will have that effect). The de facto marriage between the Ethereum blockchain and the DeFi lending products serves as a blueprint of sorts, and at this point DeFi lending is well established as a force in the anticipated financial markets of the near and distant future.
How do regulators view decentralized lending?
If there is one potential threat to DeFi lending, it is the same concern that clouds the crypto sector more broadly: regulation.
Publications such as Reuters terms like “freewheeling” have been thrown around to describe the state of crypto lending. These types of terms are generally the ones that catch the eye of regulators.
With its massive and growing popularity at the expense of billions of dollars invested, there is no doubt that discussions of DeFi loans have already been held in the offices of the Securities and Exchange Commission (SEC). But an unanswered question remains: How exactly does the SEC handle DeFi lending platforms?
There is some fear that these platforms will receive treatment similar to Initial Coin Offerings (ICOs). In 2018, ICOs became tied to unsavory phrases like “securities fraud” and “conspiracy” when the SEC took legal action against multiple crypto companies. Taking CNBCs on the SEC’s message: “new digital financial products must follow traditional securities rules”.
If this turns out to be the case with DeFi lending platforms, then there may come a time when regulators start enforcing the “traditional securities rules” that may or may not govern decentralized lending products.