DeFi set to transform lending market

One of the most popular features of decentralized finance (DeFi) is lending. It is fair to say that this feature is expanding to take a significant share of global financial lending space simply because it is easy to use and removes the barriers to accessing loans in the traditional financial system.

Bank loans are not available to everyone

Lending and borrowing are one of the core offerings of the traditional financial system, and most people are familiar with the terms in the form of mortgages, student loans, etc. These are usually granted by banks, which take measures to minimize the risks associated with providing a loan by conducting background checks such as Know Your Customer and credit scores before a loan is approved. It’s a system that is closed to those who cannot pass the banks’ requirements.

The role of smart contracts

DeFi, by contrast, is a system where lending and borrowing can be conducted in a decentralized manner wherein the parties involved in a transaction can deal directly with each other without an intermediary or a financial institution. That’s because DeFi uses smart contracts.

Crypto as loan collateral

A bank will not accept your crypto as collateral for a loan, whereas crypto is central to DeFi platforms. Users can deposit their coins into a DeFi protocol smart contract and become a lender – or a borrower. Usually, the loans are over-collateralized to account for unexpected expenses and risks associated with decentralized financing.

Choosing a DeFi platform for lending or borrowing

The best way to assess which DeFi platform is best for lending or borrowing is by looking at its TVL – total value locked. TVL is a measure of the assets staked in smart contracts and is an important indicator used to evaluate the adoption scale of DeFi protocols as the higher the TVL, the more secure the protocol becomes. The TVL in DeFi protocols has grown by over 1,000% from just $18 billion in January 2021 to over $110 billion in May 2022. One of the best sources for checking TVLs is https://defillama.com/

Perhaps most importantly, the transparency provided by DeFi platforms is unmatched by any traditional financial institution. These platforms also allow permissionless access, signifying that any user with a crypto wallet can access services from any part of the world. Although you’ll need to check each platform, as some DeFi services are not available in certain jurisdictions, e.g. a European platform may not give access to US citizens, and vice versa.

DeFi protocol gets a global rating

In what is a first for DeFi, if not the entire crypto sector, the DeFi protocol Compound Treasury announced that it has received a credit rating of B- from S&P Global Ratings. According to Compound, this is the first time a major credit agency has issued a rating for an institutionalized DeFi protocol.

The S&P Global Ratings provides a scale of investment suitability, ranging from AAA (extremely strong) to D (in default). A score of B- indicates, “the issuer can meet financial commitments, though vulnerabilities to business, financial and economic conditions persist.”

S&P revealed that in arriving at Compund’s rating they had to consider “the uncertain regulatory regime for stablecoins, such as USDC. stablecoin-to-fiat convertibility risks and the Compound Treasury’s “limited capital base” along with a 4.00% per annum return obligation” in making the decision. However, the rating agency also said that the Compound protocol’s record of zero losses measured in USDC partially mitigates the risks of the offering.

Compound Treasury’s general manager Reid Cuming commented, “S&P’s rating helps our institutional clients more easily understand the opportunity and risks of crypto-powered cash management.” It is continuing to have discussions with S&P regarding the rating and said, “Compound Treasury’s ratings could be upgraded in the event of greater regulatory clarity for digital assets or a longer track record of solid performance.”

The Compound Treasury and its yield is supported by its underlying DeFi lending Compound protocol. To date, some 301,650 liquidity providers have deposited $6.94 billion worth of digital assets into the protocol, while 9,275 borrowers have taken out $1.83 billion worth of loans. Compound Treasury’s yield is above that of savings accounts at major US banks, however at the moment, the yield from Compound Treasury is only available to accredited investors or those meeting significant income and net worth thresholds. 

Should DAOs become the form of governance for DeFi?

According to the latest annual report from KuCoin Labs, “If DeFi aims to reduce regulatory risk, the form of DeFi governance will gradually become a DAO.”

The report further predicts that decentralized finance (DeFi) will still be a significant trend in the crypto industry in 2022. It points to the fact that the DeFi ecosystem has been “plagued by criminal whales” and that this has raised the prospect of increased risk. This situation has prompted calls for the regulation of decentralized finance; calls that come from inside the ecosystem in addition to pressure from external bodies.

With regulators more keenly scrutinizing DeFi, Kucoin predicts the industry may turn to DAO governance to reduce regulatory risks, and that is because “a DAO that puts community interest first can carry out “true governance decentralization.” It forecasts that the industry will see a shift in DeFi governance being coordinated using different mechanisms.

In relation to that, Kucoin’s report suggests, “the fundamental operational principles of DAOs are reasonable enough to be employed as foundations for the creation of legal entities.” However, this may not happen immediately. Rather, it is likely that we will not see a DAO expansion this year, but that there will be a refinement of the mechanisms instead, in preparation for adoption by companies and corporations.

To give a real life example of the use of DAOs in governance, we can look at the Marshall Islands in the Pacific. The islands now recognize DAOs as legal entities, meaning that they can register and operate legally within the island nation’s jurisdiction. It could be said that this represents proof that the DAO governance structure is indeed starting to become more prevalent in the blockchain world.

Ultimately, it concludes that 2022 is not likely to be the year where we see a breakthrough in DAO expansion, but rather we will see the refinement of their mechanisms that can pave the way for future adoption on corporate or company-size levels.

DeFi: the escape route from TradFi

How does DeFi differ from TradFi (traditional finance) and what is the difference for the user?

DeFi (decentralized finance) aims to disrupt the finance market by cutting out the middleman, for example, your bank. It focuses on borrowing, lending an market making and allows investors to directly interact with each other on a peer-to-peer (P2P) basis by providing loans or liquidity for trading and assume those roles/functions in return for generating fees. Marc Bernegger,  tech entrepreneur and AltAlpha Digital crypto hedge fund co-founder, describes what has happened, “The disruption of the banking sector, which we have seen in the recent years driven by FinTech players, has now escalated to the next level with DeFi laying the groundwork for a peer-to-peer ecosystem.” 

There are four ‘tools’ that have enabled DeFi to grow. They are:

  • Artificial intelligence
  • Big data
  • Cloud
  • Distributed ledger technology (smart contracts & blockchain)

What is the problem with TradFi?

The TradFi space, while well established, presents some significant barriers to entry for portions of the population. For example, in emerging economies there are large portions of the population (50-70%) that have no access to banking.

By contrast, DeFi is a digital assets space that can be accessed 24/7/365, with services and global network coverage being constantly expanded and improved. Its accessibility has drastically increased with the spread of Internet coverage and cheap smartphones in all economies.

However, while DeFi sounds great in theory and has been shown to work in practice, there is still a long way to go. The topic remains complex and hard to grasp for many potential users. User interfaces and processes still have plenty of room for improvement and simplification, fees can vary, resulting in unreasonably high charges for smaller transaction amounts.

How you can make money with DeFi

There are two ways: you can either invest in the DeFi projects/protocols by buying the respective tokens while expecting capital gains through price increase based on a superior platform offering, user and asset growth. Or, you can actually use these platforms as an “operator” and generate income from the various activities available. These are:

  • Staking
  • Lending
  • Liquidity provision
  • Yield farming

What you should look for in a DeFi project

When doing your due diligence on any DeFi platform, the key things to look at are:

  • Team
  • Technical
  • Tokenomics
  • Insurance
  • Pools

This is a new industry that is growing in front of us, and while it still has to mature, it is changing the face of finance, especially if you want to obtain a loan, or want to make money by lending yours. No TradFi service offers you this with such ease.