By Cihan Duran, Associate, and Alexandre Birry, Chief Analytical Officer, S&P Global Ratings
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.
Lending through decentralized finance (DeFi) platforms doesn’t pose an imminent threat to traditional lenders. This could change with the removal over time of hurdles such as collateral requirements and volatile digital assets.
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…
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