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Decentralized Finance lending track insights: from principle disassembly to market trend analysis
2023 Global Decentralized Finance Lending Track Insight Analysis Report
Introduction
Lending is the beginning of everything in the financial market; it is the source.
Whether it's "The Wealth of Nations" or Mankiw's economics textbook, we can easily understand that the core of financial activities is built on the foundation of trust between people. Trust allows individuals to lend funds or assets to each other, thereby optimizing the allocation of resources.
Lending is a credit activity, referring to lenders providing monetary funds to borrowers at certain interest rates and conditions to meet their production or consumption needs. In lending activities, borrowers can amplify their capital scale to increase returns, which is the role of leverage. However, leverage can also amplify the risks for borrowers; if borrowers cannot repay on time, it can lead to losses or even bankruptcy. To avoid or transfer this risk, various financial derivatives have been invented, such as futures, options, and swaps. These financial derivatives can be used to hedge against or speculate on market volatility. It is no exaggeration to say that finance and financial derivatives are fundamentally based on the underlying proposition of "lending."
Due to the inconveniences of centralized finance, people are turning their attention to blockchain, hoping to achieve more efficient, fair, and secure financial services through decentralization. Decentralized lending is one of the important application scenarios; it utilizes smart contracts to enable the matching of lenders and borrowers, the locking of assets, the calculation of interest, and the execution of repayments, without relying on any third-party institutions or individuals.
As of now, the on-chain DeFi lending sector has become one of the most important sectors in the blockchain market, with a TVL reaching $14.79b. However, currently, there is a lack of innovation in DeFi lending protocols, and market hotspots are gradually shifting. The question facing innovators is how to innovate on the basis of existing models and integrate the latest technologies.
The DeFi lending sector needs a new narrative.
Part 1: DeFi Lending Principles Breakdown - How Decentralization is Changing the Development of Financial Lending
The distributed transformation of financial infrastructure: from traditional finance to "Decentralized Finance"
A core function of the financial sector is to channel savings into productive investment opportunities. Traditionally, savers deposit their money in banks to earn interest; banks then lend the funds to borrowers, including businesses and households. Crucially, as lenders, banks screen borrowers to assess their creditworthiness, thereby ensuring that scarce capital is allocated to its best use.
During the screening process, banks combine hard information and soft information, with the former including the borrower's credit score, income, or educational background, while the latter is usually obtained through extensive relationships with the borrower. From this perspective, the history of financial intermediaries is an exploration of improving information processing. For borrowers who are difficult to screen, lenders may require collateral to secure the loan, thereby alleviating information asymmetry and coordinating incentives. For example, entrepreneurs often have to pledge their home equity when applying for loans. If they default, lenders can seize the collateral and sell it to recover losses.
For centuries, collateral has played a ubiquitous role in lending, with loans secured by real estate existing as far back as ancient Rome. As time passed, the market vehicles and forms changed, and DeFi lending platforms brought together depositors and potential borrowers without a central intermediary like a bank. More accurately, lending activities occur on the platform—or rather, through a series of smart contracts that manage loans according to predefined rules. On one side are individual depositors (also known as lenders), who deposit their crypto assets into so-called liquidity pools to earn deposit interest rates. On the other side are borrowers, who obtain crypto assets and pay borrowing interest rates. These two interest rates vary based on crypto assets and demand for loans, while also being influenced by the size of the liquidity pool (representing the supply of funds). Platforms typically charge borrowers a service fee. Since the process is automated, loan issuance is almost instantaneous and associated costs are very low.
A key difference between DeFi lending and traditional lending is that DeFi lending has limited ability to screen borrowers. The identities of borrowers and lenders are hidden by encrypted digital signatures. As a result, lenders cannot access information such as the borrower’s credit score or income statements. Therefore, DeFi platforms rely on collateral to align the incentives of borrowers and lenders. Only assets recorded on the blockchain can be borrowed or pledged, making the system largely self-referential.
A typical DeFi loan is issued in stablecoins, while the collateral consists of higher-risk unsecured crypto assets. Smart contracts assign a haircut or margin to each type of collateral, determining how much minimum collateral the borrower must provide to obtain a given amount of loan. Due to the high price volatility of crypto assets, this results in over-collateralization—the required collateral is often much higher than the size of the loan, with minimum collateral ratios on major lending platforms typically ranging from 120% to 150%, depending on the expected price appreciation and volatility.
The outbreak period (2019-2020) was a phase of rapid growth for the DeFi ecosystem. During this period, the on-chain lending market exhibited characteristics of diversification and innovation. Not only did more DeFi projects join the market competition, but also more lending protocols innovated and optimized to meet different user needs and market environments. These lending protocols involved various crypto assets, including stablecoins, native tokens, synthetic assets, and NFTs; or adopted different risk management methods, including collateral ratios, liquidation penalties, insurance pools, and credit scoring; or designed different interest rate models, including fixed rates, floating rates, algorithmic rates, and derivative rates; or implemented different governance mechanisms, including centralized governance, decentralization, community governance, and token incentives. These lending protocols also achieved a higher degree of interconnectivity and synergy, providing users with richer and more flexible financial services and opportunities for returns through smart contracts and composable strategies. Lending protocols that emerged or developed during this period include Aave, dYdX, Euler, and Fraxlend, each with its unique advantages, while also facing challenges and risks.
Expansion Period (2021 to Present) The on-chain lending sector faces more challenges and opportunities. On one hand, with the congestion of the Ethereum network and the rise in transaction fees, lending protocols are beginning to seek cross-chain and multi-chain solutions to improve efficiency and reduce costs. Some lending protocols have already been deployed on other public chains or have adopted cross-chain bridging tools to achieve asset and data interoperability, such as the all-chain lending protocol Radiant. On the other hand, with the demands and attention from the real economy and traditional finance, lending protocols are also starting to explore the possibility of bringing real-world assets (RWA) on-chain to expand the scale and influence of the lending market. Some lending protocols have attempted to convert assets such as real estate, automobiles, and notes into on-chain tokens and provide corresponding lending services, with representative lending protocols including Tinlake, Centrifuge, and Credix Finance.
The core elements of Decentralized Lending
Whether it is decentralized lending based on blockchain technology or traditional lending based on financial institutions, their core components have certain similarities. Regardless of the lending method, elements such as borrowers, lenders, interest rates, terms, and collateral are required. These elements constitute the basic logic and rules of lending, and also determine the risks and returns of lending. In decentralized lending, various parameters are determined by the DAO, thus adding a governance module to the entire financial model. Specifically, it includes the following elements:
Borrower: A borrower refers to the party that needs to borrow funds, typically having financial needs such as investment, consumption, or emergencies. Borrowers must submit a loan request to the lender or platform and provide necessary information and conditions, such as loan amount, term, interest rate, and collateral. After obtaining the loan, borrowers are required to repay the principal and interest to the lender or platform in the agreed manner and timeframe.
Lender: A lender refers to the party willing to lend funds, typically having some idle capital they wish to earn a certain return on. Lenders need to provide their funds to borrowers or platforms and accept necessary information and conditions, such as loan amount, term, interest rate, risks, etc. After lending the funds, lenders need to recover the principal and interest according to the agreed method and time.
Platform: A platform refers to a party that acts as an intermediary or coordinator in the lending process. It can be centralized institutions such as banks, credit unions, online lending platforms, etc., or decentralized systems such as blockchain, smart contracts, and DeFi platforms. The main function of the platform is to provide a trustworthy and efficient lending market for borrowers and lenders, facilitating the matching and flow of funds. Platforms typically charge certain fees or profits as compensation for the services they provide.
Governance: In decentralized protocols, indicators such as interest rates, collateral asset determination, and LTV are all derived from voting with governance tokens. Therefore, governors play an important role in participating in protocol decision-making. Governors typically need to hold or stake a certain amount of governance tokens to obtain voting rights and governance rewards. Governors can influence the development direction and parameter settings of the protocol by proposing or supporting proposals.
Breakdown and Organization of the Lending Process Steps
The decentralized lending process is similar to centralized lending, involving similar steps, including the initiation and processing of loan requests, the provision and management of collateral, and the repayment and settlement of loans. The characteristics of decentralized lending are that it does not require trust in any intermediary, but instead operates through smart contracts to automatically execute lending agreements. The process of decentralized lending is as follows (see Figure 2):
On decentralized platforms, there are generally different collateral pools corresponding to assets with different risk levels. Their lending rates, collateral ratios, liquidation rates, and other parameters vary. Borrowers first need to select a collateral pool based on the assets they are collateralizing, then deposit their collateral into the collateral pool contract, and thereafter receive the assets they have borrowed. Due to the difficulty of verifying credit on-chain, decentralized lending often opts for over-collateralized lending, meaning the value of the collateral/item / loan amount > 100%.
After selecting the collateral pool, the borrower can input the type and quantity of assets they wish to borrow. The platform will display the corresponding loan term, interest rate, collateralization ratio, and other information based on the current market conditions and collateral pool parameters for the borrower.