Understanding Decentralized Lending

One of the successes of DeFi has been decentralized lending, which has passed $50 billion in TVL in 2022. With just US consumer debt reaching $15.6 trillion in 2021, the potential for decentralized lending to grow is significant. Powered by DeFi, decentralized lending could reach global audiences, potentially creating markets in places where a lending/borrowing market didn't exist. This article will give you an overview of decentralized lending

How does current lending market work?

For developed markets, loans are readily available. Mortgage loans for houses, auto loans for cars, and school loans for colleges are common. The process to get a loan involves applying at a financial institution such as a lending company or bank. After applying, the financial institution has the final say in whether you’re approved or not. For loans of large amounts, such as mortgage loans or auto loans, the asset the loan is taken out on is used for collateral in case of a default. 

Unfortunately, for people who live in developing markets, getting a loan may not be even possible, except for those who are wealthy or well connected. Many developing markets lack a trusted credit system and the ability to collect in case of default by the lender may be abysmal. These factors lead to a market where only the privileged few can get loans why others lack the ability to get loans for college or to start businesses, which stymies their economic growth. How can decentralized lending be a remedy?


How does decentralized lending work?

Decentralized lending is essentially peer-to-peer lending where conditions of each loan are governed by smart contracts. To take out a decentralized loan, you must have collateral. DeFi lending protocols usually set a Loan to value ratio (LTV). For example, if the LTV ratio was 50%, that means that to borrow $1,000 worth of a USD stablecoin you would need to deposit collateral of a different coin or token worth $2,000. Why borrow then? If you have saved up $2,000 worth of ADA and have a need for short-term cash but do not want to spend your ADA, you put it up as collateral. However, a prominent reason people do this is arbitrage. If the person sees a price differential on two different exchanges, they can try to take advantage of this price differential by buying a digital asset on a cheaper exchange and selling on a different exchange at a higher price to make a profit. 

There is a liquidation risk for the loan. Some platforms set a maximum LTV ratio before the smart contract liquidates your collateral to cover the loan amount. For example, if your loan had a maximum LTV of 75%, that means that the value of your ADA could not fall any less than $1,333 before your collateral is liquidated. 

The other party to the transaction is the liquidity provider (LP). LPs deposit their liquidity into the lending platform liquidity pool. Their funds are used for loans to borrowers. In exchange, LPs receive a portion of the interest fees generated. However, LPs risk their liquidity because if the collateral of the borrower drops too fast and the lending platform can’t liquidate the position fast enough to recoup the loan amount, the LP’s funds are used to cover this loss and replenish the liquidity of the platform.


Why isn’t decentralized lending a Trillion-dollar market yet?

Many borrowings happening now on lending platforms like AAVE, an Ethereum-based lending platform, are from arbitrageurs taking advantage of price discrepancies on different exchanges. In the United States, around 90% of all consumer debt are mortgage loans, student loans, and auto loans. These are loans where most borrowers can’t provide liquid assets as collateral that is more than the loan they are seeking. 

Could you give decentralized loans to people without collateral to cover the loan amount? If that person defaults, is there any recourse to collect the loan amount? What if that person lives in a different country? Most liquidity providers would not provide their capital in this situation. If you default on a loan from the bank, you could be sued, your assets such as your house or vehicle can be seized, your income could be garnished, and you could even face criminal charges in some countries. 

For liquidity providers to provide capital without collateral, there must be trust. For trust to develop, users must build credit. If each person had a digital identity (DID), users could pay bills and other expenses, which builds their credit. Over time, their credit could be high enough where liquidity providers are willing to provide capital without being 100% covered by collateral. There are identity solutions, such as IOG’s Atala Prism, who are creating digital identity solutions.