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The Coming Crisis in the Decentralized Lending Market

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BeInCrypto

Sun, Jan 16, 2022

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The decentralized loan market can easily grow exponentially because of its advantages over traditional lending.

Giving and receiving loans in cryptocurrencies has become extremely popular since the advent of the Aave and Compound credit protocols, which allow users to offer cryptoassets for interest or use their value as collateral to borrow other assets.

Analysts note, however, that these platforms operate more like a pawnshop than a bank, requiring borrowers to over-collateralize their loans.

However, this particular collateral scheme is the most popular one in DeFi today, since the traditional mechanism for assessing the reliability of borrowers (a credit rating) is not applicable in decentralized finance.

Every day it becomes more obvious that the system of excessive collateral on loans is becoming the main barrier to the development of both decentralized lending and the entire DeFi segment.

This may lead to a sharp drop in the income of lenders and a collapse of the decentralized lending market.

To reverse this trend, the DeFi industry needs to learn how to make loans with low collateral or, ideally, none at all.

That’s why many companies are fighting against the impending stagnation by creating more attractive conditions for clients in terms of the volume of collateral and loan rates.

The most radical example is the Liquity project, launched in April, which offers interest-free loans where borrowers must maintain a minimum collateral ratio of “just” 110%.

Compound expects Treasury to generate more dollar-denominated liquidity, potentially making loan rates more attractive to borrowers.

Compound Labs’ main competitor — the Aave platform — is developing a limited form of unsecured lending through a loan delegation mechanism .

The inclusion of the debt underwriter in the lending process, however, will clearly make loans more expensive for the borrower and reduce the lender’s profit.

It provides under-collateralized loans to a limited number of proxies, whose reliability has been preliminarily assessed by Cream Finance experts.

This model requires a potential borrower to pledge their digital assets into a smart contract and set the parameters of the loan, including the term, amount, interest rate, time, and amount of each loan payment.

But that’s not all: the new EIP-3475 algorithm used by DeBond allows the lender to issue derivatives on outstanding loans, packing them into new bonds with different combinations of risk and return.

DeBond’s attention to the mechanism of bonded loans is well-justified, since bonds are the main instrument of corporate lending today.

If DeFi manages to launch instruments similar to traditional bonds, decentralized finance can become an important market for corporate debt and an influential segment of the global financial market.

After all, as Cream Finance rightly noted in its presentation, the $70 billion market for direct bank lending is “a pittance when compared to the size of all US corporate debt which at year-end 2020, soared past $10 trillion.” Want to talk about defi or other topics?

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