Part 1: Intro to Lending & Borrowing Mechanics

NOTE: This is NOT investment advice. This primer series should only be used as a reference to understand the working of different DeFi lending & borrowing operational models.

DeFi: Crypto Use Case Operated to Create Actual And Valuable Utility

After what happened the last few months with Celsius, 3AC, and now FTX, DeFi lending & borrowing models have gained meaningful traction in a short period. This primer provides a comprehensive view of lending & borrowing within DeFi.

The purpose is to understand that the technology and strategy fortifying DeFi borrowing/lending models may eventually prove transformative despite a lack of market maturity.

As many have mentioned over the years, the most significant advantage of DeFi is that it enables anyone, anywhere, to participate. By refraining from traditional intermediaries, DeFi has significantly reduced the barriers to entry and the cost of participation for those who still do not have access to several financial instruments & services in the TradFi world.

Just as the Internet was arguably the first large-scale application of connecting computer technology, DeFi is already arguably more impactful than blockchain, crypto and the concept of web3 combined.

DeFi is Far From Being Mainstream, But the Momentum is Gradually Building

The premise that blockchains will disrupt traditional financial services rests on the idea that people will be empowered by access to previously unavailable financial services due to high barriers to entry. I believe that broader retail adoption of DeFi-based borrowing and lending will likely take quite a bit of time and is unlikely to impact consumer lending in the near term.

The entry barrier is high as users have to invest time and energy to get into the industry— and that’s before considering the money in TradFi, where depositing, managing & transacting money is among the least enjoyable things you can do.

Reasons include:

The above risks are not exhaustive.
The above risks are not exhaustive.
  1. Risk profiles and risk appetites (e.g., most tradfi users are opposed to online lenders)

  2. Lack of regulation in the lending space (decentralized lending is virtually unregulated)

  3. Scarce liquidity, i.e., credit loss, hacks, liquidity crunch, etc., where major CeFi institutions such as FTX, Celsius, BlockFi, and many more have perished.

  4. The narrow range of use cases and limited visibility into what the crypto assets are, among other things.

While each point has tremendous potential to be productized & monetized, most of the problems we see today result from these puzzle pieces falling into place at different rates.

However, it’s possible that as borrowers have more ways to benchmark the cost of borrowing and lenders have more ways to benchmark the return on lending, the extended ecosystem of DeFi retail investors may be more inclined to leverage crypto assets. Such platform interest income may help fuel the growth of decentralized lending protocols.

With adoption, these barriers should disappear, and actual mass adoption will hopefully result from better consumer education, competition, availability, and scalability. Put simply, DeFi would become more attractive, more user-friendly, and more transparent.

There are a large number of inherent challenges and uncertainties in figuring out:

  1. how to on-ramp to the crypto world,

  2. what accounts and wallets to set up, where to purchase altcoins,

  3. how to transfer coins,

  4. determining which coins are legitimate, how to engage with DeFi platforms,

  5. risks of borrowing/lending/staking, and – probably most importantly –

  6. how to secure your assets.

Many of these challenges exist in traditional finance because there is less competition, existing infrastructure, and institutional support. But with 20-80x return, you can’t ignore the potential and promise of DeFi.

So I expect that DeFi protocols will and should primarily focus on these three challenges:

Focus for DeFi Protocols
Focus for DeFi Protocols

While other protocols will focus on privacy, fungibility, or driving the user experience.

As an unprecedented amount of talent migrates to blockchain-focused businesses, it’s just a matter of time before most of these issues get resolved. As more legacy financial services providers embrace digital assets, onboarding becomes more effortless, bringing the masses to DeFi without having to open a new account.

As the different exchanges/wallets expand their available tokens, access expands, reducing the steps needed to explore beyond the relatively narrow list of assets available on many more mainstream exchanges. As more devices come equipped with cold storage options, the need for access to private keys is reduced, further increasing access.

The ecosystem continues to grow, and so with it, the need for scaling solutions. Ultimately, I believe that the “data network” which powers the future of the decentralized web will be, and is already, one of the largest computer networks.

So it’s only a matter of time until it becomes the most decentralized and resilient network on the planet.

Before I discuss borrowing & lending, I want to touch on the existing security problem in DeFi.

Security is absolute, and it’s a race against time. There are already many crypto projects that are advancing multiple approaches, but the ultimate goal of all of them is to replace legacy protocols with blockchain.

First of all, let me give you my definition of security.

Security is a digital asset’s refusal to change hands for insufficient value.

This general problem causes millions, if not billions, of dollars in yearly damages. And unfortunately, it appears to be wildly under-addressed in the crypto space.

Many projects aim to prevent security breaches with multi-sig wallets and voting systems. But a multi-sig wallet doesn’t solve the theft problem; it only reduces the chances of theft. And voting systems (even those based on smart contracts) require human operators.

The level of competition for personnel, training, and funding is so high that the odds of doing a fundamentally better job are minuscule. And the reality is that the best tech for securing digital assets is people. So if any crypto project is going to solve the security problem, it has to figure out a way to layer people on top of its tech.

The Impact on Legacy Lenders Should Build as New Lending Protocols Evolve

One of the innovations of DeFi is the access it gives borrowers to relatively inexpensive liquidity secured by financial assets while allowing them to maintain complete control of their borrowed funds. While most traditional banks enable customers to take out margin loans, the proceeds must be used to purchase securities in an account where the lender has custody of the assets.

Some wealthy individuals can secure liquidity against investments through their bankers, which is largely unavailable to the average retail investor. Individuals can also borrow against current pension savings, but the process can be cumbersome and come with several limitations that reduce the appeal.

By contrast, DeFi lending protocols enable borrowers to receive tokens borrowed against existing positions in an over-collateralized loan that any retail investor can then use for any purpose— whether it’s to buy a different digital asset or convert to fiat currency to do things like pay for a new car, a house or pay down debt.

The emerging DeFi industry has allowed lenders and borrowers to transact securely and efficiently acrossDeFi'snetworks worldwide. DeFi’s market value will be fertile ground for attracting crypto investors as it grows.

Because the protection collateral gives lenders against default (or risk of bankruptcy), secured loans are inherently less risky than unsecured. They tend to cost borrowers less than unsecured loans in terms of interest rates. While there haven’t been many signs that DeFi is being used to take proceeds off-chain to pay other debts, as holdings of digital assets grow, this seems inevitable, given the inherent cost advantage of secured lending vs. unsecured.

DeFi Borrowing & Lending Protocols Are Disruptive

DeFi borrowing & lending protocols are one component of the application layer of the broader crypto/blockchain ecosystem. As of November 2022, borrowing and lending are among the largest DeFi categories, with ~20.8B of total value locked (TVL), representing ~30% of the DeFi market share.

Suppose you are new to the world of DeFi. In that case, there are four primary value propositions for retail investors across the DeFi borrowing and lending space— especially when compared to TradFi services.

These Include:

The above list is not exhaustive.
The above list is not exhaustive.
  1. Composability and potential for rapid evolution: The open-source nature of DeFi projects tends to be the building block of more complex applications. As each piece improves, the applications for it grow. Invariably, new requirements are generated, which makes that piece work better. Many open-source ventures, especially in DeFi, begin with a concept and build an application on top of that concept. This provides an incentive for protocols to innovate continuously and for dApps to increment in complexity rapidly, accelerating the pace of innovation in DeFi. This composability has a couple of interesting implications.

    1. One is the potential for non-linear transition in the capabilities of linked dApps, as users can leverage the innovations of others, which could cause DeFi to evolve faster than other disruptive business models.

    2. Another is that it becomes challenging to pick winners because a protocol could develop a highly useful dApp that is subsequently improved upon by other developers who fork off with incremental advancements that supplant earlier iterations of the protocol. While this model may make it harder to determine who the winners are, it does optimize the pace of innovation.

  2. Lower operational costs. It takes several days to process a bank loan; borrowing & lending dApps provide 24/7 access to debt markets where users can instantly borrow or lend tokens with the available liquidity (i.e., loans can be repaid or withdrawn at any time). Additionally, since the underlying protocol automatically processes principal and interest payments, these applications benefit from much lower overhead costs than tradFi. However, ignoring network throughput and capital limitations, it is possible that this operating model could be infinitely scalable.

  3. Enhanced operational models. The crypto ecosystem is often critiqued for its anonymity and the potential for fraud and money laundering to thrive. Still, I believe the reality is the opposite; with high transparency, they will ultimately make the space easier to regulate than legacy financial services. For instance,

    1. The exact collateralization ratio of a given protocol is publicly available, and the protocol is constantly monitoring each borrower's health by actively tracking the value of the collateral.

    2. Another benefit of this transparency is that it makes it easier to see how decisions on DeFi protocols are made because the logic is lodged on a public blockchain, which is very different from tradFi, where the rationale behind lending decisions is often opaque.

    3. Any person or organization can theoretically audit DeFi protocols in real time so that users can identify and avoid potential financial scams, harmful business practices, money laundering, and other undesirable behaviors. ZackXBT is known to expose several financial scams, which are all possible because of enhanced transparency. Check out his investigations.

  4. New capital-raising capabilities: Many DeFi protocols employ innovative tokenomics that enable builders to quickly deploy large lending pools at a relatively low cost. This is mainly done by incentivizing the lenders through issuing native tokens that usually come with some rights to either income or voting power on the protocol.

    1. Since these tokens cost nothing to create,

      1. if the protocol ultimately fails to gain scale, the cost is zero for the capital borrowed, but

      2. if it does achieve scale, the cost is the share of ownership given away.

    2. The returns for early liquidity providers to DeFi lending protocols can be significant, making it relatively easy to get the capital needed to establish a credible protocol.

The Use Cases of Today Have Defined The Roadmap For The Future.

A common question for someone beginning in DeFi relates to “who is actually participating in overcollateralized crypto credit markets?” The answer is primarily crypto-focused traders and investors.

From a borrower’s perspective,

a user can commit crypto holdings as collateral in exchange for a loan denominated in a different crypto asset.

There are three main reasons why a borrower would seek an overcollateralized loan:

  1. Increased yield: As a depositor can maintain exposure to capital appreciation of the collateral assets while simultaneously deploying borrowed assets across yield-generating dapps or other investment strategies,

  2. Liquidity requirements: As a token holder (e.g., someone who owns ETH, etc.) can source liquidity from the protocol without selling the underlying holdings, which would trigger a taxable event, and

  3. Increased leverage can double down and construct a levered long or short position as a token holder.

The most common borrower is the sophisticated retail or institutional investor who deposits a volatile crypto asset as collateral (expecting the token value will remain stagnant or increase) in exchange for a loan denominated in another asset. This second asset is often more stable and is more suitable for generating yield/liquidity.

From a lender’s perspective,

The lender can deposit their crypto into a shared pool of assets in exchange for interest income.

With traditional bank interest rates at historic lows, many investors and traders seek ways to earn higher yields. DeFi credit markets provide an efficient method for crypto “HODLers” i.e., crypto holders intending to hold their positions indefinitely to increase returns on idle assets that are otherwise left idle.

For instance, a lender can deposit a stablecoin into a protocol such as Compound or Aave and earn a ~1-3%+ variable APY.

Recent Increase In Institutional Adoption Are Promising, but There Are Many Hurdles Still to Overcome

Several institutions, such as Paypal, Blackrock, JP Morgan, etc., play a growing role in DeFi as they roll out strategies to participate in this emerging space.

If you’d asked me a couple of years ago about active institutional adoption, it would have seemed far off because of the difficulty of forecasting liquidity and managing risks in crypto marketplaces.

But, as more liquidity providers and financial instruments such as options & derivations come into play in DeFi, we see the institutional adoption curve steepening.

I still believe that most financial institutions are in the “discovery” phase of DeFi, but face more considerable adoption hurdles related to stringent regulatory oversight and reporting requirements.

It’s also important to note that the requirements of institutions to adapt to DeFi can be mapped from the:

  1. research,

  2. pre-trade compliance, and

  3. the best execution to monitoring, reporting, and custody.

Over the last two years, there has been an explosion in products and services in all these categories, with capital flooding in to build the necessary DeFi infrastructure, which is a great sign for the DeFi ecosystem.;

Deep Dive: Lending & Borrowing Mechanics

In part 2 of this primer series, I will dive deep into two primary operating models used by borrowing and lending projects:

(Over) Collateralized but different operational models
(Over) Collateralized but different operational models

(Over) Collateralized:

  • Debt Markets: where the DeFi protocol has both borrowing and lending capabilities (two-sided credit market), and

  • Debt Positions: where the DeFi protocol only allows users to borrow crypto assets (one-sided credit market).

Part 2 of this Primer contains a brief overview of each model and an in-depth case study that examines the inner workings of specific protocols leveraging the different models: Compound, Aave, and Maker.

Read Part 2 of the Primer Series here: Deep Dive: Compound, AAVE & MakerDAO.

Thank you for reading through. I’d appreciate it if you shared this with your friends, who would enjoy reading it.

You can contact me here: 0xArhat.

My previous research:

  1. Decoding & Democratizing web3

  2. P2E: A shift in gaming business models

  3. Stablecoins: Is There Hope?

  4. Unlocking the Potential of Decentralized Data

  5. Primer on L2 Scaling Solutions

  6. Understanding User Dynamics in DeFi

  7. Centralizing Blockchain Ecosystems

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