DeFi Lending: Overpromised, Under-delivered (For Now)
Caleb Mah
The History of DeFi
Decentralized Finance (DeFi) likely began as a community effort in retaliation to the elitist and clubby routine of traditional finance (read: a group of elderly gentlemen and women sitting round the table deciding the fate of the world). The maze of regulations surrounding the club was seen as protectionist, serving as an impossible barrier to the common man.
People sought an alternative reality with solutions and workarounds to liberate themselves from these traditional chains. The concept of high returns for minimal risk – an endeavour as old as time – should not have been restricted to the remit of a few. Therefore, while not entirely an end in itself, Defi hoped to eliminate the central control that banks and other financial institutions wielded on money.
The movement spawned thousands of communities, each championing its own coin or token. But at the core, followers craved stability amidst the volatility of mind boggling returns, like ships seeking safe harbour after a storm – and there were many. The need to trade each of their own coins or tokens as a medium of exchange for stability was perhaps the genesis of stablecoins – anchored in some way whether by value or platform. With trade, came the need for liquidity and leverage, birthing a decentralised lending and borrowing system. Lenders would stake their token into liquidity pools, yielding themselves a deposit rate in return for locking up their tokens. The deposit rates are in turn funded by borrowers who pay the prevailing rate in return for liquidity. The depth of the liquidity pool determines the rates, replacing a system traditionally played by market makers. There’s no onboarding or approval process or dealing with pesky sales who sell you everything but the service you seek. Without an intermediary, transactions are executed instantly and with minimal transaction cost or fuss.
No Trust Required?
Anonymity. Any bank loan officer will cite the 4Cs – capital, capacity, collateral and character. As someone once pointed out, banks will only loan money to those that have the most and need it the least because it’s the safest thing to do. Here in DeFi, there are no credit scores, no income statements to provide, no moral questioning of any sort. You can’t see who you’re lending to or borrowing from. But do you need to?
Not that there isn’t a cost to all this of course. Nor are the mechanics really all that simple.
In order to protect lenders against collateral price volatility and the risk of default, collateral margin requirements can tower above the loan size (120-150%). In some instances, a liquidation threshold exists – below this threshold, any lender can seek to liquidate and seize the collateral for repayment (and keep the change). In others, borrowers are also incentivized to overcollateralize to avoid forced liquidation during price fluctuations. All these mechanisms act in tandem to mitigate credit risk.
Like traditional finance, collateral reliance is prone to procyclicality. Price appreciation increases collateral value, leading to relaxed borrowing constraints and increased loan volumes. Conversely, loans are liquidated as prices decline sharply (the value of posted collateral follows suit!).
All Comes Crashing Down
The whole LUNA debacle wasn’t the first in cryptoland, nor the last. It’s just physics – when pushed far and hard enough either something breaks or the energy is dissipated into oblivion. There were uncanny equivalents in traditional finance – think subprime and Lehman and the tsunami of QE that followed. Blowups will always be a feature of life. The silver lining of course, are the modifications and adjustments made ex post, even for DeFi.
TerraUSD(UST)/Luna lulled users into a overly strong sense of security with its wide range of applications, promise of scalability and high yields (20%!) through the Anchor protocol, and most importantly its highly sophisticated minimal human intervention algorithm for exchange rate self-regulation and adjustment. There’s a ton of literature out there, but in short, Luna and UST was designed as an interchangeable pair to maintain the 1 UST peg to 1 USD and the pool controlled by burning either to mint the other. Amidst general weakness in crypto markets, the UST peg started to wane, triggering a “bank run” as investors converted their UST to Luna and the panic outflow that ensued into other cryptocurrencies meant few takers for Luna and threw into doubt Terra’s mint-burn mechanism. The drawdown on and value diminution of Luna Foundation Guard’s Bitcoin reserves cemented the vicious cycle and its own demise. There was nothing magical in the pain that followed, wiping out US$2Tn in market value. Almost like Soros and the BoE, without the perpetrator.
Why Traditional, Centralized Finance Stays
In traditional finance, there is a concept known as a “lender of last resort”. The Central Bank plays this role, standing firmly behind anyone who poses a systemic risk and needs bailing out. During the Great Financial Crisis, the greatest bailouts seen in the history of mankind was orchestrated by a handful of seemingly wise men in a very exclusive setting. The most often heard term then was the Great Depression and the need to avert it whatever the cost. When the fate of many depend on the wisdom of few, it’s no wonder people are so blase. But can we really handle the inherent instability and duress that comes with decentralised control. It’s not so different in the context of cryptocurrency, which touts being decentralized and unregulated as its main selling points. Just bear in mind that history always repeats itself albeit in a different form, so it doesn’t hurt to be insured against major financial losses in the event your investing platform of choice falls apart.
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