A Recipe for Making DeFi Lending Sustainable and Stable

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The world of decentralized lending has been rightly referred to as the “Wild West” more than once. By removing human oversight, new protocols have been able to offer impressive yields on many of their services, but at the huge cost of lowered stability. 

Many are waking up to the fact that this is unsustainable and unnecessary, as market manipulators are crushing retail investors on a regular basis. New mechanisms for tapping into legacy credit may restore balance while decentralized and cryptographic proofs can ensure that honest actors run the show.

What’s Wrong With DeFi Lending Today?

DeFi is still in its infancy. While at its peak almost  $100B moved through myriad blockchain networks, the sector’s  volatility has prompted a plunge to around $30 billion. The space is filled with platforms that offer financial products that parallel those offered by TradFi companies. However, there are some key differences.

First, decentralized protocols are run entirely by code, not organizations. Smart contracts define how these financial services operate, with no human oversight. When it comes to lending, this means there are no checks in place to scrutinize lenders or borrowers. 

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The way the system predominantly dealt with this is through overcollateralization. In this model, a borrower needs to put forth more capital than they are being lent to protect the platform against illiquidity in the face of defaulting loans.

However, in addition to market inefficiency, this also led to widely varying interest rates. Early on, investors were understandably drawn to the highest yields on their lending, but this proved to be unsustainable. 

As the amount of users increased, such lucrative returns couldn’t be maintained while still supporting sufficient collateralization. It became clear that this model wasn’t going to work for bringing DeFi lending to a global or institutional audience, and something had to change.

Can We Bring New Stability To The Ecosystem?

Now, DeFi protocols are looking at strategies beyond overcollateralization as a means to bring long-term stability to the digital lending field. They are leveraging something known as “DeFi Credit.” It translates to bringing existing, verified, and real world collateral onto the blockchain and using it to support debt.

To accomplish this, platforms work with existing credit financing companies in order to establish the terms and conditions of a given loan. Once the borrower and lender have come to an agreement, the deal is both registered with the credit firm and the loan is tokenized on-chain.

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This creates a tangible bridge between the worlds of DeFi and legacy finance, but it really does more than that. It diversifies the forms of capital that can be utilized for decentralized lending. 

Acceptable real world assets can vary wildly, but are covered by any valued commodities that don’t originate from the blockchain. Gold and other precious metals, property, real estate, bonds, company shares and more can be utilized for DeFi credit. Because these assets are being appraised and secured via trusted financing companies, uncertainty in the industry is reduced, and the need for overcollateralization diminishes. . 

It’s true that utilizing real credit for decentralized lending leads to somewhat smaller yields, but it also brings far greater stability and sustainability. Loans are underwritten with clearly defined value, greatly reducing issues of illiquidity or runaway defaults. It can open the door to greater institutional trust and eventually global integration into major economic ecosystems.

What About Privacy and Trust?

This stands to be a major innovation for the future of decentralized lending and there are already projects working to make it a reality. Along the way, appropriate systems will need to be leveraged to ensure trust and stability. For example, lenders may need to go through various forms of Know Your Customer (KYC) verifications to validate their identity and credibility. 

Alternatively, blockchain native solutions can also bring accountability to this field. For example, decentralized; sovereign; and private IDs can be deployed that create verifiable and persistent histories for all involved parties. These profiles would stay with an individual or business indefinitely, acting as both, a wallet and unfalsifiable history of all financial activity and holdings.

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Thanks to the possibilities of Zero-Knowledge (ZK) cryptography, all of this information can be used for verification while still maintaining privacy. ZK tech allows for information to be confirmed and then run through an algorithm to create an unfalsifiable proof that can be utilized in place of revealing specific information. This offers the possibility for these IDs to have complete veracity, without being an open book about the user behind them.

For example, a lender can confirm that a borrower has a minimum sufficient credit score or assets under management without requiring their entire financial history or net worth. IDs can be embedded with an up-to-date credit score based on a given entity’s portfolio and past transactions without the need to reveal sensitive details. Such decentralized profiles are already being deployed, bringing powerful new possibilities to businesses and private users alike.

The Road Ahead

There are many possibilities, but this is just the beginning. The takeaway is that decentralized technology offers powerful new tools for financial benefits to both individuals and organizations, but there needs to be greater stability and security. 

Fortunately this is possible by leveraging assets and credit derived from legacy sources. Doing so can help anchor and legitimize DeFi; helping bring new money into the system.  All of this can be stabilized and enforced with both traditional KYC techniques and modern decentralized identification mechanisms. The net result is a financial world that is more efficient, fair and accessible for every level of the global economy.

Amit Chaudhary is Head of DeFi Research at Polygon.