Why DeFi is the future of secured lending | The Radix Blog | Radix DLT

March 6, 2022

Secured lending is when an asset (such as cash) is loaned to an individual or company and the borrower is required to post collateral, which is an asset that the lender can seize if the borrower defaults on the loan. The loan is secured by the collateral.

Secured loans are typically less risky (for the lender) than unsecured loans, as the collateral can be used to pay off the loan if the borrower defaults, and so interest rates can be lower. Common examples of secured loans include mortgages, which are secured against the value of a property; loans secured against vehicles or machinery, enabling businesses to make large capital investments without needing all the cash up front; or loans secured against financial assets, such as stocks or bonds.

Secured lending is particularly suited to DeFi, as tokens can be programmed with smart contracts to automate much of the process. Moreover, there is no longer a need for a bank; tokens allow lenders and borrowers to instantly move into and out of positions; and in the event of default, the collateral can be automatically liquidated to pay off the loan, as guaranteed by the smart contract.

How secured lending works today

Lending today is undertaken by regulated financial institutions such as a bank.

In order to lend, the lending institution must first have some liquid capital. This can come from either depositors, such as those who keep a current account at a bank; it could come from a loan from another financial institution; or in the case of a bank, it could just create the liquidity on its books through fractional reserve banking. We are now ready to lend.

In order to originate a loan, the credit risk and quality of the collateral is assessed. If this passes, the amount, repayment schedule, and contractual right to seize the collateral are legally agreed between the borrower and lending institution. Following agreement, the borrower gains access to the loan — and she repays this over time and with interest. If the borrower defaults, the lending institution can take possession of the collateral and can liquidate (sell) it in order to pay off the loan.

The lending institution makes money as the interest rate that it pays for liquidity (such as customer deposits in the case of a bank) is lower than the interest rate it charges borrowers. This difference is called the spread.

To bring this to life, loans secured against financial assets are one type of collateral used in secured lending. They are most commonly used by companies or wealthy individuals to make large purchases or payments without needing to sell the asset used as collateral. For example, an individual may use a stock portfolio of $100,000 as collateral to secure a $50,000 loan for home renovations (in this case the loan is overcollateralized); or a company may use its holdings of government treasury bonds as collateral to finance the acquisition of another company.

How secured lending works in DeFi

In DeFi, there are no intermediaries: everything is peer-to-peer and orchestrated through tokens and smart contracts. Instead of a lending institution facilitating the matching of depositors with borrowers, DeFi today uses liquidity pools.

A liquidity pool is a supply of tokens held in a smart contract that participants can add or take tokens from if certain conditions are met. Both lender and borrower can interact with the pool without even knowing the other exists, creating a two-sided marketplace. This peer-to-pool (or even pool-to-pool!) relationship is incredibly powerful and goes some way to solving the agency problem — which is when a financial intermediary can take advantage of the participants it represents — as the agent is replaced by an immutable smart contract.

Let’s see how liquidity pools are used in the most common form of secured lending in DeFi today — overcollateralized variable rate lending.

For the lend side, a lender deposits a token, such as USDC, into a pool of the same token, held by a dApp. The lender receives a token representing a claim on a share of the pool in return. For example, on the most popular DeFi lending dApps today, such as Aave and Compound, these are known as aTokens and cTokens, respectively. If the lender wishes to withdraw his funds he returns the claim token to the dApp which sends him back his share of the tokens (such as USDC) held by the pool, which includes his original deposit plus fees or interest paid by borrowers accrued over time.

For the borrow side, the borrower must first overcollateralize the amount borrowed. This means depositing a token that serves as collateral into the dApp, for example 1 ETH. If the value of 1 ETH is $4,000, she is able to borrow an amount lower than that, for example $3,000 USDC. The liquidity for this USDC comes from the original tokens that the lender deposited. In this scenario, the borrower has a loan to value ratio, LTV, of 75%.

If she ever wishes to regain access to her ETH collateral, she must pay back the $3,000 USDC plus interest. If the value of ETH were to fall below $3,000 plus her interest owed to date, she is liquidated, and the ETH is sold automatically by the dApp on a decentralized exchange such as Uniswap — or may be automatically offered for purchase at a discount by a third party, another peer-to-pool mechanism.

Various parameters such as the list of allowed assets and LTV and liquidation thresholds are determined by the dApp. The interest rate for both lenders and borrowers is an emergent property of the dynamics of the market and changes automatically depending on the ratio of loaned and borrowed assets, hence the name overcollateralized variable rate lending! One interesting product to have emerged in 2021 is Fuse from Rari Capital. Fuse allows anyone to set up their own pools with any combination of ERC20 tokens and any parameters, with risk isolated to each pool.

But why borrow, if you must first have more than the amount borrowed?

In traditional finance, lending secured by financial assets is useful as you can gain access to borrowed cash without needing to sell the asset used as collateral, such as the aforementioned stock portfolio. In DeFi, it’s the same thing — the borrower can gain access to borrowed cash without needing to sell the underlying asset, such as ETH. In both cases the borrower is willing to pay interest as they gain utility from the transaction, and the lender gains interest on capital they wouldn’t otherwise be doing anything with.

For the market as a whole, the presence of secured lending creates opportunities for leverage, resulting in more liquid markets, as well as more optimal allocation of capital as participants with high conviction can borrow and take stronger positions. If you’d like to understand why this is so useful for DeFi, see our blog article Why Lending is Critical for DeFi.

How DeFi makes secured lending better

If we break it down, secured lending is the process of matching liquidity that isn’t needed today, such as customer deposits (i.e. long term liquidity) with liquidity that is needed today, such as a loan (i.e. short term liquidity). The risk of default is secured by collateral, and there is an interest rate spread to incentivize both sides of the market.

Automation lowers spread: if fundamentally all we are doing is matching two sides of a market, then surely it is far more efficient to do so through automated smart contracts than through intermediaries such as a bank.

As a result, spreads in DeFi are far lower, giving depositors higher rates and borrowers lower rates than would be possible in traditional finance. To illustrate, as of November 2021 Aave gives 2.79% interest on lent DAI, the USD stablecoin; and charges 3.96% to those who borrow. This spread is far lower than you would find at a bank.

Tokens allow for instant liquidity: through the use of tokens, both sides of the marketplace are far more liquid as every position is represented by a token that can be transferred and settled instantly. This is not possible in traditional finance as quickly exiting a position can often take days and requires approval from the lending institution.

Furthermore anyone can set up trading of these tokens on a decentralized exchange and with the right incentives can create a liquid market for an otherwise illiquid asset. See Why DeFi is the future of exchanges and trading to learn more on why this is the case.

Permissionlessness leads to equality of capital. Intermediaries such as banks serve as gatekeepers, deciding who can and cannot use their services. Even still, the majority of the world’s population does not even have a bank account, let alone the ability to use their assets, no matter how low in value, to secure a loan! The current financial system is inherently exclusive.

In DeFi, all capital is treated equally as there are no permissions. This allows for anyone to access the same financial services whether they need a loan for $5 or $500,000 (so long as transaction fees remain low). DeFi has the potential to remake global finance in a manner that is inherently inclusive.

Composability creates innovative products and services: in a DeFi ecosystem, all participants, institutions, and dApps live on the same ledger. This means that everything is composable with everything else, allowing for new and novel products and services to be layered atop one another. A prime example of this is a new financial primitive not previously possible in traditional finance — flash loans, which can generate extreme levels of liquidity using a lending dApp, without any credit risk.

What’s more, the power of yield optimization dApps comes from their ability to algorithmically shift liquidity instantly to where yields are highest. Composability between yield optimizers and lending dApps is thus crucial if a DeFi ecosystem is to really thrive — and outshine — anything that the traditional financial system can muster. If you’re interested in why yield optimization is so powerful see Why DeFi is the future of active investing.

What’s in store for the future?

The lending dApps described above offer variable rates. This is not useful if you need to plan or have guaranteed cashflows. A multitude of dApps including those such as Element have solved this problem by creating derivative products that provide fixed interest within certain risk tolerances.

However, for DeFi to truly be the future of secured lending, it must solve how “real world” assets become represented in DeFi; requiring, at minimum, clarification on the legal rights and obligations provided to holders of tokenized assets. Only with these assets in token form, as worked on by projects such as Atomix, BondAppetit and FortunaFi, can DeFi’s powers of automation, capital optimization, and inclusivity be applied to markets such as the gargantuan mortgage industry, valued at $17 trillion in the US alone.

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Radix is a public ledger entirely focused on taking DeFi mainstream. Radix has just released its game-changing Scrypto programming language tailor-made for DeFi that makes developing DeFi innovative and secure.

Originally published at https://www.radixdlt.com.

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