Credit-Based DeFi: Is it Possible?
Magic internet money meets real economic activities.
Disclaimer, NFA, all that legal stuff: All the information presented on this publication and its affiliates is strictly for educational purposes only. It should not be construed or taken as financial, legal, investment, or any other form of advice.
Hi folks,
Thanks to all of you who have subscribed in the past 2 weeks since this publication was launched. As I mentioned in the last issue, the responses have been much more wonderful than I thought. I guess after 6 years of being in crypto, people do want to hear some of my takes. Anyway, I hope you continue to enjoy this publication, and if you would like to converse in real-time or share ideas for future issues, feel free to connect with me on Twitter.
P.S. Sorry for the late issue today, we’re finalizing our workflow, expect to get this in your inbox ~1 pm EST on Tuesday starting next week.
Credit-Based DeFi: Is it Possible?
The bedrock of the world’s economy is credit. Your next-door neighbor borrows capital from the bank to expand her coffee shop, which then contributes to the overall economy and society by providing baristas with jobs and college students with a place to study. The world where we live has been operating under this system for at least the past few centuries, which then created the debt cycle. I won’t go over it since that’s Ray Dalio’s playground and he already made a gazillion amount of content on it.
To access credit, one needs to prove one’s creditworthiness, which is usually done by showing that one is a disciplined borrower, always paying back one’s debt in time. At the same time, those who are fortunate enough to not have to borrow capital are punished by the current credit scoring system and are deemed less appealing borrowers. Let me borrow money to buy 6 figures JPEGs on the internet, and responsibly pay for them in 6 months’ installments, that’ll show them!
Moreover, the current credit system is also facing discrimination issues. Even in developed countries, this is a persisting problem that still needs to be solved. Not only from the perspective of race, difficulty in accessing credit is a problem that is also faced by countries, entrepreneurs in emerging markets, and other “non-creditworthy quintessential” communities. The problem here is that once one is deemed unworthy of credit, it becomes increasingly difficult to get out of the situation since you most likely need credit to do so in the first place.
It creates a perpetual cycle that will push you further down the rabbit hole — or, if it’s the opposite, it creates a perpetual cycle that sent you to Valhalla by allowing you to borrow $2.3 billion with extremely correlated, illiquid, under-collateralized assets that are tricky to seize.
Fintech and purely online lenders help, but crypto and blockchain technology has the potential to significantly improve credit access to the whole world in a more equitable manner if implemented effectively. While crypto has not solved this problem, it is the only industry that is at least trying to. As long as DeFi stayed in its current debit-based, overcollateralized system, it will never truly disrupt traditional finance.
In this write-up, we cover the emergence of services that try to bridge real-world economic activities with DeFi. We’re only at the beginning, but it’s a necessary step in the right direction.
Here are the quick takeaways:
DeFi can create a more equitable financial system and provide easier access to capital in our increasingly digital and globalized world.
DeFi in the current debit-based system will not unlock new primitives that can further real-life use-cases.
DeFi needs to expand into a credit-based system in order to truly disrupt traditional finance.
Emerging markets will benefit the most from DeFi credit expansion in the short term due to increasing USD accessibility.
A crypto-native credit scoring system is necessary to effectively expand DeFi into the real economy, and even some centralization tradeoffs in the short term.
Real-World Integration
DeFi has boomed in the past two years but its use-cases have been primarily tied to speculations and maximized for Player-vs-Player environment as tokens are used for farming rewards. We can see that TVL pretty much almost 1:1 correlated with the broader crypto market cap and altcoins price performance.
This is ironic since the spirit of DeFi initially started as a way to create a more open and equitable financial system. The emergence of DeFi ignited the possibility of having an improved system that minimizes human-level trust with computer-level trust and transparency. However, the meltdown that has been happening in the past few weeks with centralized crypto lenders often put the wrong light on DeFi, such as in this FT article. Pantera Capital wrote a great rebuttal to all of the misinformed journalists that have been pinning the blame on “DeFi” instead of the centralized crypto companies.
In reality, the true goal of DeFi is to “improve” the current financial system, enabling a more seamless and transparent flow of capital. While there are low-hanging fruits such as increasing the efficiency of financial assets through tokenization and other financial market-focused use-cases, the ultimate form of DeFi will be its ability to provide greater access to credit as our world becomes more digital and global.
Over-collateralized Crypto Loans
The current norm in DeFi is to provide more capital than the money you borrow so that the protocols can fully do their job without trusting the borrowers. They don’t need to go through the hassle of identifying the borrower’s identity, making the assessment that the borrower is creditworthy, and implementing measures to go after the borrower in the scenario that the borrowed money is being used to buy a yacht.
In an over-collateralized system, the collateral’s value needs to be at least equal to or more valuable than the loan’s value. Typically, we are talking about more than a 50% LTV ratio. So for over-collateralized crypto loans, the mechanism is simple: Provide collateral > repay > retrieve your assets > or get liquidated.
But when it comes to undercollateralized loans, things get a little more complicated.
An undercollateralized loan allows investors to access credit by providing collateral less than the loan’s value. In some cases, investors may not need to provide collateral at all (the student debt trap, but that’s for a different post). In the legacy financial system, lenders will assess the borrowers’ creditworthiness through various standardized metrics such as a credit score, track record, and even credentials or clout. In developed markets, if a borrower can’t pay back the loan then there will be legal proceedings and other court cases. In emerging markets, you can even expect loan sharks that will physically hurt you to force payments, but I digress.
Benefits of Undercollateralised Loans
DeFi lending is extremely tiny when compared to the existing credit markets. The size of global unsecured/undercollateralized debt exceeds $10 trillion with consumer debt surpassing $15.6 trillion in 2021. If DeFi really wants to integrate, disrupt, or even replace the current financial system, it needs to venture into the undercollateralized world.
There are generally 3 main problems to solve:
How to assess creditworthiness
Integrating real-world assets (RWAs) on-chain
Measures if borrowers become bad actors
To solve these problems effectively, I can’t think of a way that doesn’t involve some sort of centralization such as relying on existing laws and the court. That said, any sort of improvements to the legacy credit system via DeFi will unlock enormous value, even if there will be centralization trade-offs in the short term. We are talking about faster transactions, reduced administrative hassle, streamlined facilitation, immutable ownership records, and real-time traceability and validation.
So let’s break this down.
Crypto Native Credit Scores
Traditionally, the lenders would need to assess you based on your credit history/repayments to suggest that you are a responsible borrower and hence give you access to credit and even lower rates. Similarly, your wallet address with a long history of on-chain transactions, such as yield farming, governance engagement, and even loan repayments could be used to form a crypto credit profile. This profile would be unique to the wallet address and may be used across various platforms to ease loan assessment, like how traditional financial institutions maintain, analyze and access your credit history.
However, this has some critical flaws. For the ordinary borrowers, specifically, those who are unbanked, there may not be enough on-chain data available and due to the pseudonymity of wallets, if a borrower defaults on a loan, he/she could switch to another wallet when applying for other loans. One method to solve it is to have on-chain IDs connected to a single wallet, but purists would argue that this goes against the ethos of decentralization. Additionally, crypto-native credit ratings seem promising in setting the foundation for fully on-chain and decentralized lending in the future though this could only happen when crypto reaches mainstream adoption. For now, the ordinary user lacks sufficient on-chain activity to form a crypto credit profile.
Nevertheless, it is important for builders to continue experimenting with different models, even if that means there will be some centralization tradeoffs. For instance, we can imagine how Soulbound tokens can be utilized as a way to store credentials on-chain, forming a basis for an on-chain credit scoring system.
Real-World Assets (RWAs)
Next, enter RWAs. @ChainLinkGod wrote an amazing thread on this topic so I won’t go too deep on it, but the bottom line is:
DeFi needs RWAs to be brought on-chain at scale.
If you think that this means it’s not fully decentralized, go lock yourself in the closet and read the last section. The point is, even once we solve the problem of onboarding borrowers on-chain and having a robust crypto-native credit scoring system, we need on-chain RWAs to balance the yield and make the economic activities real — can’t have people borrow USDC to yield farm on Ohm fork #69, you want the money to be used to fund real economic activities such as on a new restaurant, which then the debt/claim/equity associated to that restaurant is tokenized on-chain for lenders to receive yield.
We’re starting to see such real-world integration, although it’s still only touching the surface. MakerDAO decided to diversify its yield strategy by allocating $500M of DAI to US Short Treasuries and IG Corp Bond. Other projects go directly to the emerging markets as they realize that DeFi has the potential to come in as an alternative funding source to bridge the funding gap and expand credit in these markets. Goldfinch, which focuses on Mexico, Nigeria, Southeast Asia, and India has generated $100M in active loans in 12 months.
Catching Bad Actors
Brainstorming how we can prevent bad actors from running away after borrowing capital in DeFi without relying on existing laws and the governments would require a post on its own, but my belief is that it’s currently not possible (or ever will be). There will always be some sort of KYC & AML implemented, one way or another.
But if you do find a magical way to do credit-based DeFi fully on-chain with a “code is law” mentality, let me know, I’d like to invest.
Pushing DeFi Forward
People borrow capital to take risks, build more income streams, better their lives, and contribute to society. DeFi needs to continue experimenting with credit-based undercollateralized models and integrate further with real-world economies in order to truly disrupt the existing financial system and provide more equitable access to capital for the global population.
If DeFi sticks to purists’ decentralization mentality, it will never integrate with the real economy, which means that we’ll be forever stuck in a PvP environment whereby the primary use-case of these tokens are speculations.
As the world becomes more digital, the global flow of capital will become much more intertwined. Most legacy inter-jurisdictions flow of capital platforms and credit providers make money by charging an exorbitant fee as middlemen. DeFi will be in the perfect position to disrupt the existing business models and capture massive value in the process.
Yo uhh hmm
The shenanigans around 3AC that have been slowly released in the past few days were insane. Even that might be an understatement. The level of degeneracy and unnecessary risk-taking at their level can only mean that Kyle and Su were really aiming to become the world’s wealthiest people by trading magic internet money. I’ve been in the crypto space for ~6 years and witnessed many famous figures with star power come and go. I definitely did not foresee 3AC as one of those people that will have such an incredible downfall deserving its own Martin Scorseses’s movie — but in retrospect, when your fund manager starts to become weirdly philosophical and spew words such as revanchist, trust your instinct. The Dunning-Kruger effect is real.
Until next time,
Marco M.