The global crypto-market’s capitalization has reached a record value of $2.6 trillion on the back of bitcoin’s recent price surge beyond its all-time high of around $64,000 in mid-October. Growing interest from institutional investors could herald a new phase of mainstream acceptance and accelerate the development of new use cases of cryptocurrencies’ underlying distributed ledger technology (DLT). As the technology enables disintermediating existing services and products, traditional actors in the financial industry can’t ignore emerging trends in the space. One specific universe of use cases is decentralized finance (DeFi), which has experienced a massive inflow of liquidity since the summer of 2020—particularly the DeFi-lending segment.
What is decentralized finance (DeFi) lending?
DeFi encompasses the emerging financial ecosystem that makes products and services, such as lending activities, available through DLT solutions. DeFi-lending protocols enable decentralized lending and borrowing through smart contracts, which replace the usual risk functions in conventional finance. Lenders can put their cryptocurrency holdings to use and gain interest, while borrowers can receive these funds so long as they overcollateralize the amount in the form of other digital assets. This process is made possible through lending pools, all of which have their unique characteristics.
With enough collateral, any interested borrower can access liquidity. Interest rates are solely determined by an algorithm balancing the supply and demand of the assets lent and borrowed. In some cases, holders of the protocol’s governance token can vote on interest rates as part of a decentralized autonomous organization (DAO). This allows investors to be decision-makers on important parameters of the DeFi protocol.
DeFi lending offers the promise of returns and the means to avoid leaving crypto-assets sitting idle. With many native currencies being continually issued at a steady pace, investors may risk losing the value of some of their digital assets to inflation. DeFi lending can help offset this risk with interest gains.
High counterparty risk entails almost systematic overcollateralization requirements. Most lending protocols don’t allow for traditional credit checks on potential borrowers. In the absence of a credit-approval process, posting collateral is typically essential to mitigate credit and fraud risks. This, in turn, has limited the sector’s growth and its use cases to date.
Use cases remain restricted for now
Lending volumes are small but growing. We estimate that debt outstanding is slightly in excess of $30 billion, which represents a few basis points of global banks’ total lending. As of October 28, 2021, DeFi lending and borrowing protocols made up about 18 percent of the total DeFi market measured by market capitalization. The three leading DeFi lending and borrowing platforms (Aave, Maker and Compound) had a total market capitalization of about $8 billion as of the same date. This showcases the concentration of the lending and borrowing markets within DeFi.
Real risk and returns can be difficult for users to assess. This reflects the lack in many cases of consumer-protection regulations, the highly technical and fast-moving nature of the segment, and the use of different tokens in terms of purchased assets, collateral posted or interest payments. Some of these currencies can be inflated away, and it can be difficult for users to assess fiat-equivalent returns given the volatility in the valuations of various digital assets.
Regulators are increasingly aware of the growing attention from and interest of investors in crypto-markets. In September 2021, cryptocurrency-exchange and services firm Coinbase received notice of a possible enforcement action from the SEC (U.S. Securities and Exchange Commission) related to its interest-earning product, Coinbase Lend—illustrating, in our view, regulators’ increasing focus on the segment. Coinbase has dropped its plan to offer a lending program as a result of the SEC notice.
For now, most DeFi lending appears to be funding the acquisitions of other crypto-assets. There are three reasons to borrow money: 1) borrowers expect the digital asset they purchased to increase in value and lock it temporarily with its existing value to receive new crypto-assets that can be used for other means (e.g., staking or trading); 2) users need liquidity but aim to avoid a taxable event when selling the collateralized asset; 3) borrowers leverage their trading by holding an existing asset in a vault and use the borrowed asset to trade or compose more complex lending, borrowing and staking activities with the same collateral base. These overcollateralized use cases limit the threat to traditional lenders.
Innovative protocols have recently started to test uncollateralized lending. For example, protocols launched in 2020 aim to do away with collateral requirements, thanks to a credit-approval process delegated to a decentralized network of credit approvers. These approvers receive rewards for correct credit predictions in the form of native tokens, and the digital tokens used throughout are, in some cases, pegged to the dollar. Volumes remain small. Among other factors, we believe that a high annual percentage rate has restricted demand so far. However, should demand and product offerings take off, these protocols could represent the main threat to traditional finance.
Credit implications will grow in line with volumes
In our view, DeFi will be disruptive for financial-services companies even if almost all applications currently relate to digital assets. Banks, insurance companies and other traditional financial firms are considering the advantages of DLT solutions and monitoring developments in the DeFi market. Ignoring this trend might lead to a wake-up call in the future, although we think this is a few years off, given that DeFi is still in its infancy.
DeFi lending could improve the liquidity of certain digital assets. Holders of better-established digital assets can diversify their portfolios by pledging existing digital assets for the purchase of other types. DeFi lending can, therefore, improve liquidity within the overall digital-assets ecosystem.
That said, it does not come without risk. Given the typically collateralized nature of the activities, we believe that volatility in the valuations of the digital assets posted as collateral could translate into volatility in the valuations of the digital assets acquired. The volume of activities remains relatively low, but greater DeFi-lending volumes could ultimately lead to increased contagion risks between digital assets. This could also occur because of the automated liquidations that materialize if the collateral provided drops below a predetermined value. Smart-contract risks (such as bugs in the code) could also lead to losses for users, as demonstrated by certain protocols in recent months.
A new decentralized credit-approval process is required if DeFi-lending activities are to threaten traditional lenders’ positions. For now, most DeFi-lending activities appear to involve the process of using digital-asset collateral to acquire new digital assets. DeFi lending, therefore, poses a limited threat to the existing core franchise of traditional lenders. Several hurdles—whether technical, regulatory or process-linked—must be cleared before DeFi lenders can bridge the gap to traditional finance at scale. However, should recent trials prove successful, more traditional use cases could take off, and these protocols could start competing with traditional lenders.