As crypto mania and speculation diminish, it’s critical to remember that the technology’s benefit does not disappear with the value of a coin.
Recent high-profile crypto company failures demonstrate a misuse of trust and assets made possible because the organisations were working in direct opposition to the objective for which crypto was invented: to enable a public, decentralized exchange where asset self-custody is the norm.
This Critical Infrastructure Still Requires Innovation
There are numerous legitimate use cases in financial services that can usher in a more secure, inclusive, and efficient financial system and restore people’s faith and ownership.
I’ll use Decentralized finance (DeFi) lending as an example to demonstrate how this works. Decentralized finance (DeFi) lending, I believe, will help mainstream crypto. Decentralized finance (DeFi) lending worth $25 billion is caught in EVM chains, a fraction of the $16 trillion in consumer loans in the United States.
In this post, I’ll take you through the current system, emphasizing the many benefits of Decentralized finance (DeFi) financing over traditional lending, suggesting starting points where people could build, and explaining areas where software and regulatory factors that must evolve to make Decentralized finance (DeFi) widespread.
TRADITIONAL LENDING VS. DEFI LENDING
Liquid crypto assets are used to secure Decentralized finance (DeFi) loans. To compare “apples to apples,” let us compare traditional equity-backed lending to Decentralized finance (DeFi) crypto-backed lending.
Allow me to assume that you made a wise investment in Microsoft stock 10 years ago and that it has since increased in value. Eventually, you’ll be able to afford to buy a home. If you decide to sell your Microsoft stock, you may have to pay a 40% capital gains tax. An alternative is a loan backed by Microsoft shares, which is a form of equity financing. An equity-backed loan from a tech-forward bank (that isn’t your brokerage) is difficult to obtain. An underwriting group will examine your financial documents (in PDF format) to determine whether or not you qualify for a loan. Taking too long to complete a task, having high costs, and being vulnerable to fraud.
What is Decentralized Finance ?
Those who have participated in decentralized finance (DeFi) lending have experienced the “wonderful moment” of securing a loan in minutes using software, as opposed to the days or weeks it takes at a bank. You can instantly withdraw, transfer, or spend stable coins after pressing a few buttons and having your assets cryptographically validated and collateralized using a smart contract.
Cryoto currency is built on a shared ledger that all participants may access and update. As a result, Decentralized finance (DeFi) lending is less expensive, faster, and safer for consumers.
Benefits of Decentralized finance (DeFi) Lending
- Assets validated via blockchain
- A peer-to-peer underwriting marketplace and a reduction in middlemen fees
- Contracts that are codified
- Self-management of assets and data
Let’s look at each benefit individually.
Verified on-chain assets
The public ledger of cryptocurrency allows anybody to check assets in real time and implement code-based control (with the owner’s permission). In comparison to what?
Closed-loop databases are used in conventional banking to facilitate loans secured by assets. So, creditors can’t get an accurate, up-to-the-minute valuation of assets subject to frequent fluctuation. If you needed a loan from a third party, you’d have to move assets or share data between systems. This can be anything from a PDF to a phone call, or even a read-only API with a delay in its updates. No matter how sure the lender is that the assets are legitimate, it cannot act on the loan contract (such as making a margin call) until it has custody of the assets. Lenders can only offer affordable rates on large loans to the wealthy because of high operational expenses, fraud risk, and a lack of competition.
In Decentralized finance (DeFi), owners can delegate responsibility over their assets to anybody they choose. Anyone can compete for the funding of such assets. Loan amounts for decentralized finance (DeFi) start at $5,000, with much lower margins than conventional loans.
Market for underwriting and funding
Customers today are fortunate to receive 3 to 5 loan bids for a variety of reasons. Each lender’s quote procedure is unique. Most customers do not have the time to compare estimates from hundreds of lenders. Online lending marketplaces fail for the following reasons:
- Because lenders cannot automatically underwrite, they provide price estimates rather than official offers.
- It is difficult to persuade financing providers to use a third-party marketplace.
Decentralized finance (DeFi) makes coordinating and access easier. A distributed, shared public ledger enables developers and funding providers to make quick decisions based on verifiable facts. Customers profit from this since it allows them to compete on underwriting and price.
P2P Marketplace, Middlemen Fee Reduction Software that connects borrowers and lenders directly eliminates gatekeepers and raises prices.
Contracts based on codes
Loan agreements (including capital commitments and covenants) are now extensively monitored through trust, PDFs, and legal action. Loan agreements are automatically executed via smart contracts. Rapid, scalable, secure, and affordable.
Self-management of assets and data
Self-custody is unfeasible in closed-loop systems. It is difficult to trade or sell paper or digital stock certificates. Self-custody decreases counterparty risk in crypto without sacrificing security. This involves both cryptography and data. Third parties control the current banking system.
Traditional lending wastes time, endangers lives, and keeps people out of the system. This prospect, when combined with developer inventiveness and competition, has the potential to change the loan industry.
How can we make it better? And How will it Expand?
Decentralized finance (DeFi) lending is favourable in theory. It is currently niche and underdeveloped.
Obtaining a Decentralized finance (DeFi) loan necessitates the possession of crypto assets. Decentralized finance (DeFi) financing is exclusively available to early crypto users. Regular individuals cannot use non-crypto assets as collateral, nor can they link their identity to a wallet address in order to borrow based on their reputation. There is no marketplace that directly connects borrowers and lenders, and scalability and privacy are lacking.
I envision five areas that must be developed in order for Decentralized finance (DeFi) lending to become a mainstream system:
- On-chain assets from off-chain
- Identification, credit, and wallet addresses are linked.
- Borrowers, lenders, and underwriters are all in demand in this market.
- Infrastructure for scalability and privacy
- Regulations that are unambiguous
Each of these sectors is ripe for new cryptocurrency uses and businesses.
Examine each one.
NON-CRYPTO ASSET TOKENIZATION
I can’t use Decentralized finance (DeFi) if I don’t want to sell non-crypto assets like stocks, bonds, houses, autos, and jewellery. Infrastructure is required to connect the financial world with liquid capital markets and crypto developer innovation. What is the best asset class?
Individuals and corporations in the United States have secured loans totaling $20 trillion. Three criteria determine whether assets are brought on-chain initially. Optimisation for:
- AR/AP factoring for small businesses accounts for $147 billion in lending volume in the United States and requires no licence. Because there is no digital source of truth or consistency, these contracts are difficult to shift on-chain. MakerDAO collaborated with HVB to fund a portfolio of business loans.
- Consumer benefit: Tokenizing illiquid assets can provide significant value, but it is challenging due to legislative and operational constraints (standardizing value and accessing real-time price feeds). Illiquid assets are being tokenized by Goldman Sachs.
- Tokenizing liquid assets, like as public shares, is simpler to implement since it does not require verified investors, provides real-time price feeds, and standardised digitally custodied securities. In the United States, it is a $12.5 trillion, $200 billion asset class. The benefits of tokenization are incremental, and there are still regulatory impediments to creating and trading assets. In the past, centralised exchanges provided “tokenized” synthetic equities, but they were limited to such exchanges and not ideal for Decentralized finance (DeFi).
I’ll start with public stocks because they are the quickest method to provide true benefit to people.
“The Circle of Equities”
On-chain representation of public equities
Circle has achieved this by reflecting US cash on-chain. On-chain currencies reduce cryptocurrency volatility while preserving an open, global payment system. Even during “crypto winter,” stablecoin volume exceeds $500 billion per month. In the future, assets may exist on-chain. Infrastructure is required between now and then.
Circle receives $1, invests it in US treasuries, and returns 1 USDC to me. When I’m finished, I (or anyone with USDC) will trade 1 USDC for 1 USD. In the interim, Circle has earned 4% on the funds I invested in US treasuries. I’m overjoyed since I was able to transmit and receive value more easily than if I had kept cash on hand.
NewCo. might hold my 100 Microsoft shares and issue me 100 MSFT-D tokens, each worth one share. I could then use these shares as collateral for a Decentralized finance (DeFi) protocol loan, which capital sources could finance immediately. This NewCo. must deal with the regulatory complications of issuing digital shares, as well as KYC for on-ramps and off-ramps, as well as a blacklist of wallet addresses that are not eligible to acquire tokenized stocks. Everything else on-chain is handled by market makers and developers. Transaction fees and custodied stocks could be monetized by the custodian.
The Value of Tokenization
Why tokenize stocks?
Today’s traders/investors are constrained by their brokerage’s back office software. Tokenized equities allow investors to participate in a public ledger where developers can create risk- and wealth-management solutions. This includes (1) competitive/low-cost margin lending, (2) immediate settlement to high-return stablecoins (vs. 3-day settlement and no yield on cash), (3) software tools that can instantly control risk through hedging strategies, and (4) access to a global, 24-hour marketplace.
IDENTITY AND WALLET ADDRESSES
- Data management; low-interest loans
- Unsecured personal loans, excluding credit cards and student loans, are the next step for Decentralized finance (DeFi).
Assuming data is on chain, the benefits of crypto rails include:
- Data verification and monitoring in real time, independent of source.
- There are millions of underwriting algorithms that can compete.
User-controlled information
Decentralized finance (DeFi) lending presently employs pooled vaults with pre-Decentralized finance (DeFi)ned terms for borrowers and lenders because to insufficient on-chain data. Because there is no way to determine a wallet’s “credit score,” everyone is viewed as a bad actor, resulting in higher fees and collateral requirements.
We need privacy-preserving solutions to link real-world identities, credit ratings, assets, and income to a wallet address in order to offer unsecured personal loans on-chain. It is necessary to address over-reliance on a single reputable source. Identity preservation must be assured. Is negative behaviour erased if you default on a Decentralized finance (DeFi) loan and then create a new wallet address? Is it recorded “off-chain,” or is it detectable on-chain? Credit will be more expensive if your identity is not permanent. Individuals should decide whether to “permanently” attach their identity to a loan in exchange for a cheaper interest rate.
This field is being developed by Spectral (on-chain credit scoring), Privy, Burrata, Jomo, Astra, Quadrata, Sealance, and Polygon ID (off-chain APIs), and Carapace (on-chain risk management).
Individuals and organisations will be able to disclose financial data on-chain through the use of zero-knowledge proofs, a mathematical approach that validates truth without revealing the underlying facts.
Lenders may cryptographically verify that I am an American citizen earning more than $x with a FICO score of 750 without revealing my salary or linking it to my identity. Millions of bots, underwriters, and finance sources can then go through the data and compete to fund debtors.
This strategy is preferable to the current scenario, in which gatekeepers make the rules. Wallet addresses that wish to remain anonymous must pay an additional fee (more collateral, higher prices). Individuals are willing to spend less to selectively disclose more info (income, assets, bank statements, etc.).
People reveal far too much information, while lenders examine far too little. Cryoto currency gives users and developers access to massive data sets. This improves financial access while preserving privacy.
Borrowers, lenders, and underwriters can all trade in this market.
Developer competition and inventiveness
After tokenizing stocks and tying identities to wallet addresses, we need a decentralised marketplace to match borrowers, lenders, and apps. The status quo for Decentralized finance (DeFi) is pooled vaults with fixed terms. Future marketplaces will be fully automated.
We need a decentralised order book for lending, similar to how Uniswap’s AMM works for trading. Lulo and Morpho were among the first to enter. Early order books for lending failed due to liquidity.
Ox’s “Matcha” product is one solution. Matcha is a decentralised exchange aggregator that facilitates trade between users and developers. One may create a lending protocol aggregator that tries to match borrowers and lenders directly but defaults to the best rate available.
Creating infrastructure for scalability and privacy
Consumer lending on cryptocurrency rails necessitates low-cost, high-throughput infrastructure with transactional privacy and compliance. Ethereum networks are costly and based on public ledgers, with each transaction associated with a wallet address. This is not scalable in terms of consumer finance. Espresso, Chia, zkSync, Aleo, Aztec, Aptos, and Mysten are all promising initiatives in this field.
Clarity in regulatory terms
We require regulatory clarity on how to deal with security tokens. We require a regulatory framework that protects consumers and investors while still allowing for innovation. What exactly is a security, how are they managed, who is a lender, and how are gains and losses taxed?
Meanwhile, Decentralized finance (DeFi)’s “permissioned trading pools,” such as Aave Arc, ensure regulatory compliance. Regulatory clarity will aid in the mainstreaming of cryptocurrency over the next crypto summer.
A real-time, global, open financial system has far-reaching consequences. Consider a similar situation in the 1990s, when news organisations began posting online. The advantages of digital journalism over print include instant access, lower publishing costs, and an open read/write system. However, someone who reads nyt.com instead of the physical New York Times will not understand the internet’s true potential until they use digitally native outlets such as Twitter (notwithstanding current drama).
Decentralized finance (DeFi) lending creates a quick, open, creator/developer-led system for value rather than information.
If Decentralized finance (DeFi) becomes widespread, it will have an impact on more than the $16 trillion US consumer credit market. Outside of the United States, few individuals have credit, therefore purchasing a phone, car, house, or business takes cash. If you can quickly and affordably exchange and verify assets and income using code, you can let more people join the modern financial system.
I’ve Decentralized finance (DeFi)ned the infrastructure required to make Decentralized finance (DeFi) lending mainstream. This paradigm is applicable to payments, gaming, and collections. As a result, the system will be more accessible and intelligent. While tourists are on their way to the next hot place, builders will be able to unlock the next trillion dollars.