Linda Xie: Where is the future of decentralized finance?

Written by: Linda Xie, co-founder of Scalar Capital, a blockchain investment institution, and early product manager of Coinbase

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mortgage

mortgage

One of the biggest complaints people have about the decentralized finance space is that the system always needs to be over-collateralized to get a loan. After all, no one wants their money locked up. In fact, mortgages were designed with the belief that capital was extremely inefficient, and many people didn't have the extra capital, and if you look at the $500 million in mortgage funds locked up across the industry right now, you can understand why the market has this demanded.

For example, you can lock up $200 worth of ETH, borrow $100 worth of DAI, and then you can use the borrowed DAI to buy another $100 worth of ETH. Another reason people try to mortgage is that they don’t want to sell their crypto assets, because holding crypto assets will involve tax issues, so they may prefer to use their cryptocurrency as collateral to obtain a loan.

Of course, there are also some people who are "enthusiastic" about encrypted mortgages because they feel that this model is more streamlined than the traditional financial system and does not need to go through complicated KYC (know your customer) compliance processes (however, in terms of risk compliance, decentralized Finance will eventually change).

Not only that, some people outside the traditional financial system will also find decentralized finance to be very beneficial, and once the collateral rate has declined, the collateral use will become more prominent.

But it’s worth noting that we’re still in the early days of DeFi. At this early stage, complaints about over-collateralization are largely due to the system's lack of a proper decentralized identity and reputation system. Not only that, but at this stage there is no legal system to deal with related issues, so the only way to make lenders feel "comfortable" is to require borrowers to overcollateralize.

Whether people think that the DeFi system should exist or not, market demand speaks for itself, and existing DeFi projects just make it easier for people to accept related services.

If borrowers do not want to sell their cryptocurrency holdings, especially if they are excluded from the traditional financial system, there are not very good alternatives in the market at present. The same is true for lenders, you can choose not to earn interest on encrypted assets, such as using centralized financial services, which will take a large fee; or deposit fiat currency in a bank account, and the bank will hold your Money lends money, but most of the interest income they earn does not go to you.

Therefore, it is clear which is better. While DeFi still has a long way to go, for both borrowers and lenders, this nascent space has already taken an important step forward.

If a better identity and reputation system is introduced in DeFi, the requirements for collateral will be reduced. At present, many banks and other financial sectors in the United States rely on credit institutions, such as Experian, TransUnion, Equifax, etc., to confirm personal credit.

Credit bureaus can disadvantage groups such as expatriates and young people. Some P2P lending services (such as Lending Club) will rely on scores from the FICO scoring system when solving traditional financial services problems. This system will provide some additional data information, such as home ownership, income and employment time. Decentralized identity and reputation services can also provide similar functionality, which may include other information such as social media reputation, previous loan repayment history, other reputable user guarantees, etc. However, this solution is not a panacea that can cure all diseases. It also requires a lot of testing and trial and error, and constantly explores which evaluation data and collaterals need to be obtained.

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Composability

Composability

One of the most unique aspects of DeFi is composability.DeFi protocols can be plugged into each other like Lego blocks, and then create something completely new. For example, Dan Elitzer proposed such an idea:Transferring collateral to the so-called "overflow"

(superfluidity) in different systems.

This means that you can take collateral from one protocol and "loan" it to another protocol. However, one of the main problems here is that the "compounding smart contract" (compounding smart contract) is very risky, and for overcollateralization, the most important thing is to ensure that the borrower will not fail to return the principal of the collateral used. If the collateral is lent elsewhere and there is a problem, then this collateral is no longer useful.

Although some people in the industry are dissatisfied with this "super-traffic" system, due to problems such as low circulation efficiency caused by a large amount of funds being locked, people will inevitably try this concept. Therefore, what we can do may be to self-regulate, or set up a "guardrail", such as a minimum mortgage rate.Lianwen Note: Regarding the concept of "super-traffic", you can refer to the article published by Lianwen by IDEO CoLab investor and MIT Bitcoin Club founder Dan Elitzer: "」

The Future of DeFi: What Will the World Be Like With Liquid Cryptocurrency Collateral?

Interestingly, many of these processes in the future may be abstracted from some non-encrypted native users. For example, users may only need to take some risk tolerance tests and/or select their risk score to understand which DeFi protocols are available to them, similar to the solution Wealthfront presents to users now.

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assets

assets

The author personally likes the idea of ​​bringing more tokenized assets such as Bitcoin into the DeFi field. In a bull market, if DeFi services are readily available and cheap to create and redeem, then there should be a lot of demand for using Bitcoin in DeFi.Lianwen Note: For thoughts on the practice of DeFi on the Bitcoin blockchain, you can refer to the article previously published by Lianwen, Token Daily partner Mohamed Fouda: "」

To make Bitcoin DeFi possible, there are these methods and use cases

I believe crypto custodial service providers are in the best position to offer a centralized version of this type of service because funds can be easily locked up by customers.

Many large investors are required to hold their funds with a qualified custodian because self-regulation is not a viable option for some people (or projects). Custody providers could offer an option to tokenize custodial assets and allow people to trade them, which could become another revenue stream for the custodian. For example, Wrapped Bitcoin (WBTC) already exists in the market, but the fees they charge are high, which is also one of the obstacles to popularization in the market.

However, as the market competition and the number of users continue to increase, the cost will eventually decrease. This is the case with cryptocurrency custody rates, which have seen a significant drop due to the growing competition in the crypto custody market and rising monthly active users. Take Coinbase Custody as an example. They were officially launched in July 2018. At that time, the rate was 10 basis points per month, but in August 2019, it has dropped to 50 basis points per year. Many people believe that this figure will change over time. decrease further.

Moreover, compared to the centralized version of token assets, the decentralized version of assets will eventually become popular and coexist with it.

At present, the vast majority of people using DeFi are native cryptocurrency users, but traditional investors may also use DeFi or a system similar to DeFi in the future. Some stablecoins actually "borrow" the concept of DeFi, for example, USDC is loaned out and re-borrowed on the DeFi platform.

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risk

risk

While DeFi is very attractive, you have to admit that it is risky.

DeFi systems are usually relatively new, and some may only have been in operation for a few months, so there are obvious smart contract risks. The risks are compounded when many smart protocols interact and build new contracts on top of each other.

If this risk did not exist, it is now clear that a lot of money can be lent out on DeFi protocols (if more people try to benefit from high interest rates, current interest rates may drop significantly).

In addition, there are other risks in DeFi, such as the collateral used to back the loan. Greater risk arises if the price of a certain collateral (token) falls so rapidly (even over-collateralization cannot explain the volatility of some assets) that margin calls still cannot cover all the funds borrowed .

However, some DeFi platforms today have reasonable overcollateralization ratios and acceptable collateral types, so potential loan defaults are not as much of a concern as smart contract risks.

As the volume of transactions continues to increase, the DeFi industry will definitely introduce more regulation in the future, such as the need for KYC. More regulation may reduce the liquidity of some projects, and some people who cannot meet regulatory requirements and provide suitable documents may not be able to access the DeFi system.

Of course, the specific situation will vary from person to person, and will involve various factors such as product type, jurisdiction and decentralization. Although some DeFi projects use the name DeFi, at the current stage, many projects are not very decentralized.

Given these risks, people are starting to discuss whether some of these risks can be hedged through the use of decentralized insurance.

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Summarize

Summarize

In general, we must be clear that it is still the early stage of DeFi, but the potential of the industry is huge. DeFi not only allows many people who are excluded from the traditional financial system to obtain financial products, but also creates some new financial products that people have never seen before.