Undercollateralized Loans in DeFi - Why the future of lending is decentralized?

For 1.7 billion individuals worldwide, traditional credit markets are still mostly inaccessible. To begin, you'd need a credit score and assets (collateral) or income to entice the banks' credit assessors. Without even mentioning the enormous red tape and long loan approval processes by traditional banks.

To remove these limitations, decentralized lending platforms like Aave (AAVE), Compound (COMP), and Maker (MKR) allow anybody anywhere to acquire loans (MKR). There's no need for bank accounts or lengthy credit checks with the initial generation of decentralized lending protocols. But there is a problem with this type of trustless, overcollateralized loan - collaterals. Underbanked or unbanked users can't afford (or don't have) the requisite crypto collateral. We need a new solution for these individuals - uncollateralized crypto loans are the answer.

The Birth of DeFi Lending with Overcollaterized Loans

With no third parties and no KYC processes, decentralized money marketplaces like Aave run trustlessly. Undercollateralized Loans in DeFi are heavily overcollateralized to preserve their trustless nature. This implies consumers must deposit more than the loan value. For example, a 70% collateral factor means that $100 in collateralized deposits only permits users to borrow $70 in assets. The collateral is locked to mitigate counterparty risk, diverting funds that could be used more productively elsewhere. Overcollateralized loans are just inefficient capital allocation.

Then there's the use of overcollateralized Undercollateralized Loans in DeFi and their target demographic. Serving the unbanked may seem wonderful, but overcollateralized borrowing does not reach those in need. Rather, it is typically employed to enter a leveraged long position by recursive lending and borrowing. This has allowed many crypto maxis to obtain rapid consumption without selling stakes. Instead of selling your ETH to buy an iPhone 20, you may deposit it on Aave and borrow USDC/USDT to buy the phone.

That's excellent, but how can I receive a loan if I don't have enough money? That's why I needed the loan in the first place! Imagine asking for a $200k mortgage but being told to put down $300k first.

Undercollateralized Lending

Over-collateralized loans are beneficial but not for the typical borrower. The crypto over-collateralization requirement prohibits most borrowers from engaging. Crypto loans can be made more accessible by eliminating or reducing the demand for collateral. The concept may seem impossible, yet there are existing DeFi protocols that provide such a service to their consumers.

Undercollateralized Loans in DeFi are loans that are not fully or even partially collateralized. In the event of default, the collateral (if any) will not cover the principal. The market for uncollateralized lending (including non-collateralized lending) may be divided into eight types:

Per Defillama, lending and borrowing account for the second-largest market in DeFi, immediately behind Decentralized Exchanges (DEX), with approximately $44 billion in TVL (excluding borrows) at press time.

While significant, it is dwarfed by the $11 trillion loan market in traditional finance. Researching Undercollateralized Loans in DeFi will be critical in allowing users to get loans without the usual red tape and complexity that traditional finance entails.

Even within the crypto ecosystem, undercollateralized lending is still not the preferred alternative for lenders and borrowers. As of February 2022, the TVL of undercollateralized lending protocols was only $1.2 billion, which is less than 3% of overall lending TVL. Clearly, the community prefers third-party assessment protocols now, with Maple Finance, TrueFi, and Goldfinch leading the pack and Wing Finance filling out the top four as a credit native assessment platform. However, bear in mind that this doesn't include flash loans, another sort of no-collateral loan.

For this article, we're going to talk about flash loans, third-party risk assessment, and crypto native credit scores, which are the three most popular options to extend credit that isn't fully collateralized.

Flash Loans

In the crypto sector, flash loans are the most common type of Under collateralized loans. In 2021, Aave's flash loan volume hit $3 billion. A flash loan involves borrowing and repaying the loan in a matter of seconds, as the name implies. Because both borrowing and repayment must take place simultaneously, there is no risk for either party because any deviation will result in the transaction being reversed.

Flash loans have a bad reputation due to their involvement in several DeFi protocol attacks. However, the majority of them are used for arbitrage. Flash loans are designed to allow arbitrageurs to swiftly profit on price differences between two platforms in a single transaction. Peer-to-peer lending, collateral shifting, and strategic self-

That being stated, a flash loan is intended for specialized uses and is not intended to be used in conjunction with traditional loans or to serve the ordinary borrower.

Third-party Risk Assessment!

Aside from flash loans, third-party risk assessment is the most prominent undercollateralized lending option. Interestingly, this sort of loan mimics the regular financial industry fairly closely, with the proviso of being decentralized and on-chain.

A bank's internal credit team/credit committee generally verifies, evaluates, and approves debt products based on the applicant's risk profile. Similarly, Goldfinch and Maple Finance protocols add a third-party credit assessor between lenders and borrowers to assess risk. If a default occurs, the collateral pledged by users who desire to function as credit assessors will be cut first. Conversely, they are rewarded for timely loan payback. On Goldfinch, there is a second stage of verification by third-party auditors to validate the information given by the borrowers. This is similar to the maker and (multiple) checker method used by financial organizations.

The human level checks introduced by third-party risk assessment help screen against high-risk candidates and potential frauds. Thus, DeFi may be used for personal loans, microfinance, and even prime brokerage, allowing borrowers to get funds without collateral. This allows for future on-chain lending and borrowing on additional protocols.

Overall, if properly implemented, this may be a realistic, decentralized alternative to the conventional loan approval methodology used by banks.

Crypto Native Credit Scores!

Imagine applying for a loan with no or bad credit. The bank would have a tough time assessing you because there is no evidence to base their decision on. However, a long history of punctual credit card payments suggests that you are a responsible borrower. As a consequence, lenders will be more willing to lower lending rates.

In the same way, a wallet address with a long history of on-chain actions, such as loan repayment, yield farming, governance engagement, etc., might be utilized to build a crypto credit profile. This profile is unique to the wallet address and may be used across different platforms to help ease loan evaluations, similar to how traditional financial institutions maintain, access, and analyze your credit history. But this strategy has severe flaws.

In terms of the ordinary borrower, especially those who are unbanked, there is just not enough on-chain data available. Because wallets are pseudonymous, if a person defaults on a loan, they may switch to another wallet when applying. On-chain IDs connected to a single wallet (i.e., off-chain integration) is one option widely suggested, although this goes against the principle of decentralization championed by DeFi from its inception. One solution is to introduce zero-knowledge-proof (zk-proof) off-chain data.

Many projects are already working on this, like Wing Finance and EasyFi, which operate their own lending protocols. It will allow platforms to properly curate and analyze on-chain profiles, similar to how lenders in traditional finance utilize Credit Scores.

Some other means of acquiring Uncollaterized loans include:

Looking Ahead

Overall, DeFi lending is still small compared to regular credit markets, and the undercollateralized loan category is much smaller. The bright side is that there is still lots of space for development as mainstream use looms. In its current form, DeFi lending to the unbanked has limited applications. Sure, there is a compelling case for not giving credit to everyone who needs it, however, partially secured / unsecured lending on DeFi should be provided to reach a larger population.

The adoption of traditional financial procedures by undercollateralized lending and borrowing protocols is ironic but vital to bootstrap the user economy. Crypto native credit ratings seem promising in setting the groundwork for fully on-chain and decentralized lending in the future, but only when crypto reaches mainstream adoption. Currently, the ordinary user lacks sufficient on-chain activity to construct a crypto credit profile.

That being said, we are still in the early stages of Undercollateralized Loans in DeFi, and it is difficult to predict which system will prevail. Also, a new inventive option may emerge to surpass the competition. What we do know is that getting started as early as possible, even if it's just now, is very advantageous. So, get a wallet and build up your credit history; you'll need it for future loan applications.