Is the hot DeFi lending a real loan?
decentralized finance ("DeFi"decentralized finance (") took the C position in the cryptocurrency industry this year. the most popular"A protocol that lets users borrow/lend digital assets at an algorithmically established rate based on market supply and demand.
Although"Although"borrow money
The term is widely used and easily understood in everyday life, but it misrepresents the economic activity that these agreements enable. Users of these protocols are not extending credit or incurring debt, which are essential features of lending transactions. Users earn interest through overcollateralization and free market liquidation, not through borrowing.
DeFi replaces institutions with protocols"DeFi"Decentralized Finance (
)'s ultimate vision is to build an autonomous financial system that allows users to engage in a wide range of economic activities without relying on trusted third parties. The base layer of the Bitcoin and Ethereum networks already implements this vision, enabling the simple activities of sending, receiving, and holding money. DeFi tries to go further.
The core idea of DeFi is to refine the complex financial services provided by traditional institutions into its component rules and procedures, and transform them into self-executing codes --- share the permissionless and uncustodial properties of the decentralized network it relies on Autonomy agreement. So far, DeFi developers have launched protocols that enable various disintermediated economic activities, including digital asset exchange, payments, portfolio management, derivatives trading, prediction markets, private transactions, and more."One of the popular DeFi applications is the so-called"With the agreement, users can provide digital assets as collateral to earn interest, borrow other assets, and create stablecoins anchored to fiat currencies such as the U.S. dollar. DeFi users have shown tremendous interest in these protocols, with billions of dollars in inflows in the past few months alone.
image description"As of September 1, 2020,"borrow money
$3.92 billion is locked in the agreement. Source: Defipulse.com
How does the so-called "borrowing" protocol work?"There are several commonly referred to as"borrow money
DeFi protocols of protocols, each with its own unique features and features. Despite their differences, most rely on the same basic mechanisms to function: overcollateralization and liquidation."To use these protocols (for convenience, call"interest rate agreement
), users first need to provide assets as collateral to the protocol. Providing assets to the protocol feels a bit like depositing money in a bank account, except there is no third-party custody of these assets; users always maintain autonomy over their assets.
Users who contribute assets to the protocol can borrow other assets from the protocol, up to a certain limit, which is always less than the value of the collateral they provided in the first place. Since the value of collateral provided by users will always be greater than the value they can borrow, their positions are said to be overcollateralized.
If market conditions change such that a user's position exceeds their borrowing limit -- such as if the value of the collateral they provided falls, or the value of the asset they borrowed increases -- then their position could be liquidated. Liquidation occurs (often at a discount) when a third party repays some or all of the user’s borrowed assets and demands the collateral provided by the user in return.
For example, imagine you want to use an interest rate protocol to borrow DAI using your ETH as collateral. You start by providing $1000 of ETH to the protocol. You can then borrow a certain amount of DAI from the protocol, depending on the protocol's borrowing limit. Assuming you’re using a protocol with a borrow limit of 75% of the collateral provided, you can borrow $750 in DAI with $1,000 in ETH as collateral. Then, your position is overcollateralized by $250.
Now imagine that the market price of ETH drops by 4%. The ETH you provided is now only worth $960 instead of $1000. Your position is still over-collateralized by $210, but you have now exceeded the protocol's borrowing limit --- you have borrowed $750 in DAI for more than 78% of the value of your collateralized ETH. This means that your position will be liquidated by a third party, who can pay back some of the DAI you borrowed until the amount you borrowed falls below the limit. Here, the liquidator might repay $150 in DAI and receive $160 in ETH, making a $10 profit and making your new position $600 in DAI vs. $800 in ETH (75% limit).
It can be seen that the combination of overcollateralization and liquidation is to maintain the solvency of the interest rate agreement --- that is, to prevent the situation that users cannot recover the provided assets because other users have borrowed assets and have not paid back. As long as the user's position is liquidated while still being overcollateralized, these protocols will not suffer a loss of funds, and users can withdraw their provided assets at any time. So far, the system has proven effective, securing billions of dollars in assets through the economic incentives of free market clearing, rather than relying on trusted third parties.
The Heart of Lending: Credit and Debt"Discussing why the interest rate agreement cannot be realized"lend money"Before, we should first define"loan"lender"or"or"creditor"Borrower"or"or"）。
debtor
Borrowing and borrowing is a very common aspect of financial activities for most people. You may have borrowed or lent money at some point; in fact, you may now be a party to at least one loan. Maybe you took out a mortgage to buy a house. Maybe you have a monthly payment for a rental car or a credit card. You may lend money to a friend or family member.
The important role of trust in lending explains why we use"Credit"the word."Credit"or"believe"or"trust"trust
The meaning of something, which has a double role in lending:"First, it refers to money that a lender gives to a borrower. Lenders make money by giving money to borrowers"credit", or by allowing the borrower to pay back the money in the future to provide"。
credits"reliable"or"or"。
good credit
In short, credit is the basic feature (necessary condition) of a loan.
Cost Yield of Credit and Debt
The important thing is that every extension of credit is matched by a corresponding debt. Credit describes the creditor's trust that the debtor will repay the loan as promised, while debt describes the debtor's obligation to do so.
As parties to the loan, the creditor and the debtor accept different costs in order to pursue different interests."or"or"credit risk"。
On the other hand, the debtor gains the benefit of using the creditor's money for expenses that the debtor may not be able to afford. To obtain this benefit, the debtor pays in the form of interest"cost"cost
, this interest is usually accrued periodically -- usually monthly, sometimes weekly or daily -- until the loan is fully repaid."The debtor also runs the risk of not being able to repay the loan, which can have various negative consequences. Depending on the terms of the loan, the debtor may only have to pay some additional fees or penalties. However, in the worst case, the debtor may be in"debt spiral
, that is, interest accrues on outstanding loans faster than the debtor can repay the loan. Debt spirals can eventually lead to insolvency, bankruptcy.
As you can see, default is the worst possible outcome for a loan—the creditor can lose their money, and the debtor can go bankrupt. As a result, the financial industry has spent decades and billions of dollars building a sophisticated system for analyzing and quantifying default risk.
The system's best-known features are credit scores and credit ratings, which represent a debtor's likelihood of defaulting on a loan. Credit scoring and ratings consider factors such as the debtor's repayment history, outstanding debt, available lines of credit, and more. In the U.S., the major credit agencies -- Equifax, Experian and TransUnion -- provide credit scores for individual consumers, while the major credit rating agencies -- Fitch, Moody's and Standard & Poor's -- provide credit scores for corporations and sovereigns. Countries provide ratings."Even with solid credit scores and ratings, it is impossible to completely eliminate the risk of default; there is simply no way to determine whether a debtor will be able to repay a loan. To manage residual risk, savvy creditors will usually require the debtor to sign a legal agreement allowing the creditor to"enforce loan
. This means that the creditor can sue the debtor in court and obtain a judgment against the debtor for the outstanding loan amount. Creditors can use the judgment to seize other assets belonging to the debtor to repay the loan.
Fundamentally DeFi does not implement credit or debt
So far, we have discussed (1) the core feature of lending is how the creditor can trust the debtor's ability to repay the loan, and (2) the core purpose of DeFi is how to remove the trust required to conduct financial activities. As you can see, these systems take opposite approaches to the trust problem.
In fact, the design of the interest rate protocol does not involve trust issues at all. As noted above, their solvency and soundness depend on the mechanics of overcollateralization and liquidation, rather than credit and debt expectations and commitments.
Remember that credit describes the lender's trust that the borrower will repay the loan, usually based on the borrower's reputation for reliability and solvency. Unlike lending, asset providers to interest rate agreements don't trust the borrower to repay the borrowed asset -- in fact, they often don't know the borrower at all. There are at least two reasons for this:
First, like the decentralized networks on which they rest, interest rate protocols are permissionless by default, meaning they can be used anonymously by anyone with internet access. This means that it is difficult or impossible for the supply side to link real-world identities to specific borrowers without using blockchain analytics services."point to pool"or"or"point-to-point protocol
This means that users supply and borrow fungible assets to liquidity pools stored within the protocol, rather than supplying and borrowing to designated counterparties. This means that it is difficult or impossible for the supplier to identify any particular borrower, arguably borrowing their assets rather than another supplier's.
Instead of relying on their trust in borrowers, the supply side relies on overcollateralization and liquidation to ensure they can withdraw assets at any time. Borrowers will always have to provide more value than they can borrow as collateral, and suppliers can always expropriate this collateral through a free and open clearing market -- or have them do it for them. These mechanisms work exactly the same regardless of the creditworthiness of the borrower.
Also remember that debt describes the debtor's obligation to repay the loan. Unlike lending, borrowers who borrow assets from an interest rate agreement have no obligation to repay what they have borrowed -- in fact, borrowers don't have to make any further payments.
Rather than having the benefit of spending someone else’s money based on a repayment promise, DeFi borrowers provide up front more than the full amount they may owe later. Borrowers are then free to walk away, never repaying the assets they borrowed, without introducing any additional risk to the supply side. In doing so, the borrower loses their collateral, which will eventually be seized through liquidation. Either way, the agreement is for the full return of the supplier's assets.
In other words, the purpose of overcollateralization and liquidation is to eliminate the risk of default. The supply side doesn't have to worry about the borrower failing to repay the loan, because it doesn't matter whether the borrower repays first; by design, the supply side should get its money back no matter what. This is not to say that interest rate agreements are completely risk-free, but only that interest rate agreements do not introduce default risk, which is a characteristic of lending.
In short, because rate agreements do not involve credit or debt -- and because they do not rely on trust or expose users to default -- the transactions they facilitate are not loans.
DeFi does not do secured loans either
It's worth acknowledging that collateral isn't exclusive to rate agreements -- it plays a key role in lending as well. Nonetheless, the DeFi transactions discussed here are very different from mortgage lending.
In an unsecured loan, creditors rely solely on their trust in the debtor to repay the loan, combined with their trust in the courts to enforce those loans in the event the debtor defaults. In a secured loan, the creditor also secures the interest by using specific assets pledged by the debtor as collateral for the loan. Creditors can also try to cover their losses with collateral if the debtor defaults.
But the presence of collateral in a secured loan doesn't change its fundamental character -- it's still dependent on credit and debt. Secured creditors still have a relationship with a specific debtor that they trust will repay the loan, often using credit scores and ratings to assess the debtor's creditworthiness. The debtor secured by the mortgage still promises to repay the loan according to the loan terms in the future, and cannot just walk away after taking the creditor's assets. Such loans are still at risk of default, which can have serious consequences for both parties to the transaction.
Misuse of DeFi protocols is bad for everyone"If you're reading this, you might be wondering why so much time is spent delineating what appears to be semantic distinctions, an unnecessary exercise."borrow money
The term is well understood by the general public, so who cares if it's technically accurate?
We should all care. Far from being purely semantic, it's critical to the future of DeFi that we describe exactly what we're building and be honest about the limitations we haven't overcome."ICO"Over the past few months, the robust DeFi space has begun to show signs of a speculative frenzy reminiscent of 2017's
Foam. That bubble was partly caused by developers over-promising the potential of blockchain technology to solve all of the world's problems while soliciting money from an unsuspecting public. Almost all of them fail, and some are scams.
While DeFi differs from ICOs in key ways, the dangers of irrational market behavior are much the same. There's no way to stop people from taking risks with their assets, but we can at least help them make informed decisions. This means explaining exactly what DeFi protocols can and cannot do, and honestly acknowledging the extent of the disruption they can cause.
In the context of the protocols discussed here, it is important to recognize that the market for overcollateralized borrowing is different from the market for credit-based lending. It would be truly remarkable if any innovative technology could disrupt the trillion-dollar global credit markets, but until we know DeFi is up to the task, we should be careful to avoid such grandiose promises.
