Lending platforms — an essential element of decentralized finance (DeFi) — stand at the center of the recent crypto turmoil. Total value locked in DeFi lending protocols peaked at $50 billion in early 2022, up from nearly zero at the end of 2020. Lenders are attracted by high-interest rates that often far exceed those on bank deposits or money market funds (right-hand panel). Borrowers, in turn, use DeFi lending to gain leveraged exposure to crypto-assets or adjust portfolios.
Status
The crucial feature of DeFi lending is that it relies heavily on crypto collateral. This is because, unlike in traditional finance, market participants in DeFi are anonymous. Assessing the risk of borrowers through time-tested methods — from banks’ screening to reliance on reputation in informal networks — is therefore not possible. Whereas financial intermediaries have, throughout history, focused on improving information processing, DeFi lending in its current form has reversed this trend and tries to perform intermediation without gathering information. Instead, it requires borrowers to post collateral.
Only assets recorded on blockchains can be borrowed or pledged, making the system largely self-referential. The typical DeFi loan is disbursed in stablecoins, while the collateral consists of riskier unbacked crypto assets. Smart contracts assign each collateral type a haircut, or margin, determining the minimum collateral borrowers must pledge to receive a loan of a given amount. The high price volatility of crypto assets means over-collateralization: the collateral required tends to be much higher than the loan size. Minimum collateralization rates typically range between 120% and 150% on major lending platforms (Graph 2, left-hand panel), and depend on the expected price appreciation and volatility of the crypto assets serving as collateral (center panel).
To ensure lender protection, platforms also set a “liquidation ratio” relative to the borrowed amount. To avoid forced liquidation, borrowers normally post more crypto assets than the minimum required, leading to a higher effective collateralization ratio than the prescribed minimum (Graph 2, left-hand panel). Considering the boom-bust cycles of crypto (right-hand panel), over-collateralization and liquidation ratios do not eliminate the risk of credit losses.
Problem
Overcollateralisation mitigates information asymmetries but leads to inefficient use of capital in DeFi lending. A model of intermediation fully built around collateral undermines benefits for financial inclusion, as borrowers already need to own assets. In addition, as collateral values, and hence risk-taking capacity, tend to increase in booms and decline in busts, reliance on collateral generates procyclicality in lending volumes and prices. Importantly, anonymity and dependence on collateral are incompatible with DeFi’s aspiration to democratize finance: collateral-based lending only serves those with sufficient assets, excluding those with little wealth.
Conclusion
The work of Prestare will energize the DeFi community to drive ineffective fund usage out of the cryptocurrency realm, establishing the groundwork for more ambitious goals like a permissionless, credit economy built to support web3. By becoming the first protocol to issue permissionless under-collateralized loans with 100% on-chain information, Prestare hopes to lead this initiative.
A permissionless, under-collateralized web3.0 credit economy is being built by Prestare.
About Prestare Finance
Prestare Finance (Prestare) is a lending protocol that offers a lower collateral ratio and can even support under-collateralized loans without using off-chain information. Under-collateralized borrowing is achieved by allowing the borrower to use a portion of the previously accumulated interests as collateral to borrow more funds next time. SoulBound Token containing credit score for all users need to be minted if users want to borrow on Prestare. Users with higher credit scores can have a loan with a lower collateral ratio.