When an asset (such as cash) is loaned to a person or business, the borrower is required to post collateral, which is an investment that the lender can seize if the borrower defaults on the loan. The collateral serves as loan security.
Secured loans are typically less risky (for the lender) than unsecured loans because the collateral can be used to repay the loan if the borrower defaults, and thus interest rates can be lower. Mortgages, which are secured against the value of a property, are common examples of secured loans; loans secured against vehicles or machinery, which allow businesses to make large capital investments without the need for all of the cash up front; and loans secured against financial assets, such as stocks and bonds.
Because tokens can be programmed with smart contracts to automate a significant portion of the process, DeFi is well suited to secured lending. Furthermore, no bank is required; tokens allow lenders and borrowers to enter and exit positions instantly; 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
Only regulated financial institutions, such as banks, lend today.
The lending institution must first have some liquid capital in order to lend. This can come from depositors, such as those with checking accounts at a bank, a loan from another financial institution, or, in the case of a bank, through fractional reserve banking. We are now ready to lend.
To initiate a loan, the credit risk and collateral quality are assessed. If this occurs, the borrower and lender will legally agree on the amount, repayment schedule, and contractual right to seize the collateral. Following the agreement, the borrower gains access to the loan, which she repays over time with interest. If the borrower defaults on the loan, the lending institution may seize and liquidate (sell) the collateral to repay the debt.
The lending institution makes a profit because the interest rate it pays for liquidity (in the case of a bank, customer deposits) is lower than the rate it charges borrowers. This difference is referred to as the spread.
To demonstrate this point, loans secured against financial assets are one type of collateral used in secured lending. Corporations or wealthy individuals typically use them to make large purchases or payments without selling the collateral asset. For example, a person may use a $100,000 stock portfolio as collateral to secure a $50,000 loan for home renovations (the loan is overcollateralized in this case); 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
There are no middlemen in DeFi; all transactions are peer-to-peer and supported by tokens and smart contracts. DeFi now uses liquidity pools rather than lending institutions to connect depositors and borrowers.
A liquidity pool is a supply of tokens held in a smart contract that participants can add or remove tokens from if certain conditions are met. Each lender and borrower can interact with the pool without knowing about the other, resulting in a two-sided marketplace. By replacing the agent with an immutable smart contract, this peer-to-pool (or even pool-to-pool) relationship partially solves the agency problem, which occurs when a financial intermediary takes advantage of the participants it represents.
Let’s look at how liquidity pools play a role in the most common type of secured lending in DeFi today: overcollateralized variable rate lending.
A lender places a token, such as USDC, into a pool of tokens held by a decentralised application. In exchange, the lender is given a token that represents a claim on a portion of the pool. On today’s most popular DeFi lending dApps, such as Aave and Compound, these are known as aTokens and cTokens, respectively. Assume the lender wants to withdraw his funds. In that case, he returns the claim token to the decentralised application, which then sends him his share of the pool’s tokens (such as USDC), which includes his initial deposit plus any fees or interest paid by borrowers.
On the borrow side, the borrower is required to provide collateral in excess of the amount borrowed. This entails depositing a collateral token, such as 1 ETH, into the dApp. If one ETH is worth $4,000, she can borrow a lesser amount, such as $3,000 USDC. The original tokens deposited by the lender provide the liquidity for this USDC. The borrower’s loan-to-value (LTV) ratio in this scenario is 75%.
If she wants to use her ETH collateral again, she must repay the $3,000 USDC plus interest.
If the value of the ETH falls below $3,000 plus the interest owed to date, the borrower is liquidated, and the ETH is automatically sold by the dApp on a decentralised exchange such as Uniswap – or may be automatically offered at a discount by a third party, another peer-to-pool mechanism.
The dApp determines various parameters, such as the permitted asset list, as well as the LTV and liquidation thresholds. As a result, the term “overcollateralized variable rate lending” was coined! Rari Capital’s Fuse, which was introduced in 2021, is an intriguing product.
But why borrow if you need more than the amount borrowed?
Lending secured by financial assets is advantageous in conventional finance because it allows you to borrow money without having to sell the asset used as collateral, such as a stock portfolio. Similarly, in DeFi, the borrower can obtain borrowed funds without having to sell the underlying asset, such as ETH. In both cases, the borrower is willing to pay interest because the transaction benefits them, and the lender earns interest on idle capital.
Because participants with strong conviction can borrow and take stronger positions, the presence of secured lending creates opportunities for leverage, resulting in more liquid markets and optimal capital allocation. See our blog post Why Lending is Essential for DeFi to learn why this is so beneficial for DeFi.
How DeFi helps secured lending
The default risk is mitigated by collateral, and an interest rate spread encourages participation on both sides of the market.
Automation reduces spread: if all we’re doing is matching two sides of a market. Iit’s certainly more efficient to do so through automated smart contracts rather than through intermediaries like banks.
As a result, DeFi spreads are significantly lower, providing depositors with higher interest rates and borrowers with lower interest rates than is possible in conventional finance. Aave, for example, pays 2.79 percent interest on lent DAI, the USD stablecoin, and charges 3.96 percent interest to those who borrow as of November 2021. This spread is much lower than what a bank would provide.
Tokens enable instant liquidity
Furthermore, anyone can set up trading of these tokens on a decentralised exchange. Thus creating a liquid market for an otherwise illiquid asset with the right incentives. Visit Why DeFi is the Future of Exchanges and Trading to learn more about why this is the case.
Capital equality results from a lack of permission. Intermediaries, such as banks, act as gatekeepers, determining who can and cannot use their services. Nonetheless, the vast majority of the world’s population lacks even a bank account. Let alone the ability to use their assets as collateral for a loan, regardless of their low value! By definition, the current economic system is exclusive.
Because DeFi has no permissions, all capital is treated equally. This provides everyone with equal access to financial services. Whether they require a $5 loan or a $500,000 loan (so long as transaction fees remain low). DeFi has the potential to transform global finance in a way that is inherently inclusive.
Composability leads to the creation of new products and services
in a DeFi ecosystem, all participants, institutions, and dApps reside on the same blockchain. This means that everything is compatible with everything else, allowing for the development of new and innovative products and services. Flash loans are an example of this, as they represent a new financial primitive not previously available in conventional finance. Capable of generating extreme levels of liquidity via a lending dApp without credit risk.
See Why DeFi is the Future of Active Investing to learn why yield optimization is so effective.
What does the future hold?
The lending dApps described above have variable interest rates. This is ineffective if you need planning or guaranteed cashflows. Many dApps, including Element, have addressed this issue by developing derivative products that provide fixed interest within specified risk tolerances.
To be the future of secured lending, DeFi must first resolve how “real world” assets are represented in DeFi. Which necessitates clarification on the legal rights and obligations granted to holders of tokenized holdings.
Employ a reputable DeFi development services provider and begin your DeFi project to profit.