Crypto Lending: Decentralising the Financial System

What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.” Satoshi Nakamoto

The Decentralized Finance (DeFi) or Open Finance movement aims at pushing ahead the ideal of Nakamoto’s original vision of building a financial world that is entirely online and decentralised.

This imagined radical decentralisation of financial services refers not just to the decentralisation of risk-taking away from banks and other intermediaries — as is currently the case in capital markets — but also to credit and insurance provisions, and to the decentralisation of decision-making and record-keeping tasks.

The envisioned system offers a peer-to-peer, decentralised, global, and open financial system in which everyone participates in a network where all financial services can be created and exchanged — savings, loans, trading, insurance, amongst others — via “smart contracts” on the blockchain.

Decentralising the Financial System

The traditional financial system revolves around intermediary institutions. These include commercial and investment banks, investment funds, amongst others. Their role is to collect and pool savings from consumers and direct them via lending out to borrowers. In doing this, these intermediary institutions centralise the operations of maturity and risk transformation (by transforming short-term relatively safe deposits into risky long-term loans), and of convenience redenomination (for example by matching a pool of small deposits to a large loan).

Decentralisation and disintermediation are possible through different forms and to various degrees. However, they cover three main areas (see FSB, 2020):

  • Decentralisation of decision-making by which users or protocols (or both) could autonomously take decision on whether to engage in financial transactions, without relying directly or indirectly on some trusted financial intermediary.
  • Decentralisation of risk-taking whereby individuals or pools of individuals would directly match with investment opportunities, and hence the credit and liquidity risks would not be shifted onto the balance sheets of financial intermediaries.
  • Decentralisation of record-keeping by storing and verifying data and transaction records via a network and possibly consensus mechanisms using Distributed Ledger Technology (DLT).

Decentralisation may also mean that financial activities take place online and without a clear geographic location, hence out of the reach of national jurisdictions. Autonomous systems could manage and control access to assets and resources, without the intervention of individuals located in a given place.

At what rate will these changes happen? There is much debate on this. Some of the expectations of a super-fast change propelled by DLT during the last few years have failed to materialised (see, for example, “the Occam problem” of Higginson et al 2019). Ultimately, the rate at which decentralised technologies will be adopted will be determined by their potential in terms of efficiency gains.

Where is the Open Finance Movement currently?

It is not easy to gauge the scale of this market. Bitcoin Suisse (Hays, 2020) reports:

There is already $671 million worth of cryptocurrencies locked in Ethereum-based DeFi smart contracts, with MakerDao Dai accounting for 50% of the market. When including EOS-based DeFi applications, the figure swells to $892 million currently locked in decentralized finance smart contracts. For example, the DApp EOSRex has almost $300 million locked in it.

Smart contracts are computer protocols designed to execute a transaction once the ex-ante agreed condition of a contract is met. This technology allows the safe enforcement of a contract and makes it trackable and irreversible. These smart contracts enable developers to code financial services far exceeding the simple transfer of a (crypto)currency and are called decentralised apps, or dapps.

The idea of a loan whose terms are automatically set and enforced by a dapp on the blockchain between two strangers, without an intermediator providing risk assessment, may sound like something out of a sci-fi movie. Yet DeFi dapps already, albeit at the early stages, cover a huge array of financial services (see Coelho-Prabhu, 2020). For example, there are dapps that allow the creation of stablecoins (i.e. cryptocurrencies pegged to national currencies or assets. e.g. Maker), to borrow or lend (CompoundDharmadYdX, LoanScan), to exchange tokens and cryptocurrencies (Uniswap, 0xAirSwapBancorKyberIDEXParadex and Radar Relay), to bet on future events (Augur and Guesser), to create synthetic assets (Synthetix), and even to join a no-loss saving game where the winner collects the interest on pooled savings (PoolTogether).

Yet, despite the rapid development of this market, the current technology means that there is a strong trade-off between decentlisation and capital efficient/collateralisation (see Coelho-Prabhu, 2020). The first generation of DeFi dapps rely on heavy collateralisation as a safeguard. It is often required to already have the same or a larger value in own crypto as collateral, in order to borrow cash or other cryptos.1 Two factors are important in justifying the heavy collateralisation: the lack of traditional risk screening in trustless smart contracts, and the high volatility of the cryptoassets used as collateral.

To increase capital efficiency, smart contracts will have to rely on decentralised financial user scoring systems that should be able to provide the equivalent of credit scores, subject to them being both universal and privacy-preserving.

Conclusions: Risks and Opportunities

The upside. Decentralised financial technologies promise to radically reshape the way we borrow, lend, invest and exchange insurance provisions. A decentralised, disintermediated, granular financial system could increase the efficiency of the financial industry, by removing unnecessary intermediaries from financial transactio­­­ns and reducing the concentration of service providers. That, in turn, could also reduce solvency and liquidity risks in the system due to concentrated intermediaries relying on short-term funding for lending.

The downside. Decentralised financial technologies also entail several risks that need careful monitoring from financial stability institutions:

  • New forms of concentration risks may appear by stealth under the surface of decentralised systems, by the centralisation of platforms, assets, or codes.
  • Cyber risks due to cyberattacks and/or manipulation of consensus protocols.
  • Greater procyclicality in the supply of credit due to the aggregate behaviour of economic agents in lack of policy intervention tools.
  • Legal risks that arise when responsibility cannot be localised in decentralised financial systems.

Bibliography

Bank for International Settlements (2020), ‘Designing a prudential treatment for crypto-assets’, BIS Discussion paper

https://www.bis.org/bcbs/publ/d490.htm

Coelho-Prabhu, Sid (2020), ‘A Beginner’s Guide to Decentralized Finance (DeFi)’, Coinbase

https://blog.coinbase.com/a-beginners-guide-to-decentralized-finance-defi-574c68ff43c4

Acheson, Noelle and Galen Moore (2020) ‘Crypto Lending 101, Coindesk
https://www.coindesk.com/wp-content/uploads/2020/01/CryptoLending101_CoindeskResearch.pdf

Financial Stability Board (2019) ‘Decentralised financial technologies: Report on financial stability, regulatory and governance implications’, FSB report
https://www.fsb.org/2019/06/decentralised-financial-technologies-report-on-financial-stability-regulatory-and-governance-implications/

Hays,  Demelza (2020), ‘How DeFi is Automating Central, Commercial & Investment Banking, Bitcoin Swisse
https://www.bitcoinsuisse.com/outlook/how-defi-is-automating-central-commercial-investment-banking/

Higginson, Matt and Marie-Claude Nadeau and Kausik Rajgopal (2019), ‘Blockchain’s Occam problem, McKinsey
https://www.mckinsey.com/industries/financial-services/our-insights/blockchains-occam-problem

Footnotes

1 Bitcoin Suisse (Hays, 2020), reports that “The average amount of collateral invested in MakerDao Dai vaults is currently 319.83 % and has been as high as 600% during 2019.”

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