Lending platforms have become an integral part of the DeFi infrastructure, as protocols like Aave, Compound, and Anchor have locked up over $45 billion in combined TVL. The market so far has been completely dominated by a model where users must deposit collateral in order to borrow funds, which can be extremely limited in its scope and potential growth. On the other hand, loan models where no collateral is needed has been a widely disregarded segment that has yet to be heavily explored by the DeFi community. Let’s explore these two lending options and understand why uncollateralized debt may be the largest untapped market in crypto today.
Collateralized Lending
The main form of lending we have seen in DeFi to date has been collateralized lending, also known as secured debt, where a user deposits a token into a smart contract and is able to borrow against the token’s value below some predetermined ratio. This form of borrowing is limited for a number of reasons.
1. The Total Addressable Market (TAM) for collateralized lending has a relative cap
First, the TAM for collateralized loans is technically all assets, but in reality it should be only the relevant value of options for collateral in a given system. I would argue that on a percentage basis, collateralized lending DeFi protocols have reached very close to their limit with respect to the total crypto market capitalization. There are only so many assets that are worthy enough to put up as collateral for longer time-horizons, and a large portion of this market is already being utilized in one form or another. And while new valuable assets are constantly emerging, this increase in value is likely reflected in the total market’s growth as well. This is on top of the fact that the governance tokens for many lending protocols are extremely inflationary and do not do a good enough job in capturing protocol value. Demand has especially peaked for the borrowing and lending of non-stablecoin volatile assets. This is because demand for yield on assets will always be increasing while the demand to borrow these assets will always be limited to a subset of traders and yield farmers, and this divergence will ultimately push yields towards zero.
2. Demand for collateralized lending is directly correlated to market fluctuations
In addition to the limited scope of collateralized lending, all collateral assets in DeFi are fundamentally correlated with one another and are subject to market volatility and cycles of boom and bust. This means there are periods of higher and lower demand for leverage, and therefore the revenue for lending DeFi protocols as a whole often fluctuates based on this demand. This can also cause problems of reflexivity, as people use borrowed funds to invest in other correlated assets that if a sharp drop were to happen, the risk of liquidation increases and which would further reduce the protocol’s TVL.
3. Protocols require heavy short-term incentives to attract capital
What is likely most devastating for the current borrowing and lending platforms is that they are all fighting for the same fixed number of potential tokens as collateral. Therefore, capital flows to whatever system is providing the highest rewards for users at the present moment, whether or not this is long-term sustainable for the individual protocol. This incentivizes the wasting of protocol capital or value through inflationary token rewards or heavily reduced profit margins, and if a protocol isn’t finding ways to differentiate themself from the crowd they will likely not survive.
In order for lending protocols to succeed beyond token inflation and unsustainable incentives they will need to to capture new value in one of two ways. The first would be to capture new collateral value, whether from brand new crypto primitives or from real-world assets. Projects such as Parrot (LP tokens as collateral) and Abracadabra (yield bearing assets) have shown signs of this, but while these models may achieve large growth in the short-term even these projects will eventually reach a relative peak and fall into the same issues stated above. And real world assets do not seem very likely in the near term because people would be less likely to securitize their real world-assets as collateral while taking on the increased risks that result from bridging assets to the blockchain when rates for securitized lending are already favorable on traditional financial rails, although there are projects building with this is mind. The second (and more likely) scenario would be to introduce uncollateralized forms of lending, which may increase risk taken on by the protocol and governance token holders but will open up a much wider market of opportunity with the chance to increase protocol revenue by a large margin.
Uncollateralized Lending
Uncollateralized loans, otherwise known as unsecured debt, is a form of credit given to those without forms collateral, usually issued by large banks and given out to individuals and businesses based on some basis of prior credit or proof of future income. Due to the fact that these types of loans are riskier in nature, the financier can charge a higher interest rate and therefore generate a higher return on investment. The TAM for uncollateralized loans also becomes far larger than that for collateralized loans, because there is no theoretical ceiling to the maximum amount potentially loaned out. Also, while the potential user set for DeFi collateralized lending is restricted to those who are long crypto assets, uncollateralized lending, especially in the form of fiat currency, has no theoretical limit to its user base. So with the ever-expanding TAM and user base along with the ability to charge higher interest rates, uncollateralized lending clearly positions itself as one of the largest untapped markets in DeFi currently.
To explore DeFi protocols who have attempted an uncollateralized lending model, the only one to reach sufficient scale so far is TrueFi built on the Ethereum blockchain. Borrowers are limited to a heavily vetted set of whitelist participants who submit their loan proposals for TRU stakers to vote on whether they should receive protocol funds. While this model has been successful to date, bringing in over a billion dollars in TVL, the problem it has is that it limits the participants who can first interact with the protocol, as the whitelist to access funds is restricted. Even in the future when the DAO ultimately decides who is worthy of these loans, it will be usually limited to firms with brand name recognition or a long history of clear profitability. While these funds can bring in a large amount of TVL and revenue for the protocol, it limits its set of potential participants and essentially fails in its goal to democratize finance. And this system isn’t completely trust-less, as you need to recognize who specifically is on the other side of the lending in order to make a decision. True DeFi uncollateralized lending platforms will need to find ways to fund not only low risk funds with a long track-record, but also any individual with a potentially profitable enterprise or plan of repayment, despite the potential increase in risk they bring the protocol. How does one do this in a way that remains decentralized, permission-less, and trust-less, while optimizing protocol revenue and reducing risk?
The Case for Mars Protocol
One application with a unique solution to this problem is Mars Protocol, which is set to launch soon on the Terra blockchain. While Mars will be a wider money market with collateralized lending and the introduction of a dynamic interest model, one of the landmark features will be the offering of uncollateralized lending. The way it differentiates itself in this field, however, is rather than the DAO assessing an individual or company’s credit-worthiness, the potential borrower must submit a smart contract that verifies to the DAO the plan for profitability. Therefore, the borrower must essentially show proof of profits before he can be given funds.
This allows a much wider set of individuals to participate with the protocol, as they simply have to prove to the governance holder’s their direct monetization. It also reduces the overall risk to the protocol, as you now only have to deal with smart contract risk as opposed to counter-party or credit risk. Mars is also working specifically on a risk framework to assess the riskiness of a given smart contract as accurately as possible, which will help the protocol more accurately assign loan values and interest rates. This is converting the TrueFi model that still requires trusted parties and counter-party risk and makes the process completely trust-less and minimizes risk across the board. This model of uncollateralized lending will begin with built-in smart contracts for yield farming strategies, but will soon extend to anyone who proposes their own profitable smart contract to the Mars DAO. Through this model the MARS token is also able to retain value, as inflationary rewards aren’t warranted and xMARS stakers get a share of the increased revenue.
While this may be restrictive in the short term to only those who are crypto-native, it is not hard to reason that this is a stepping stone in what will clearly be the correct model for minimizing risk for these platforms. One can easily envision a future in which many, if not all, businesses choose to run all their financials on-chain, as it helps ease the firm’s accounting process and increase regulatory and legal compliance. Therefore, businesses themselves will be able to verifiable prove to the DAO their profitability, and therefore whether they are credit-worthy for uncollateralized loans at favorable rates. And you can also foresee that businesses will be able to program smart contracts to ensure funds are executed in a proper, autonomous, and transparent way. The provable aspect of on-chain data makes this model a fantastic primitive to reduce the default risk for the protocol, increase the number of potential users and organizations to have access to needed funds, and is set up for a future of normalized and prevalent on-chain transactions for businesses.
So, while collateralized lending suffers from a relatively capped TAM and potentially devastating short-term rewards, uncollateralized lending allows crypto to tap into a completely unexplored market with a larger potential user base and higher protocol revenue. While other protocols such as TrueFi have developed solutions that remain trusted and centralized, Mars has a unique solution that allows any user to interact with the protocol in a trust-less manner as long as a smart contract with proof of profitability is presented. Since this is mostly unexplored territory for DeFi, there will likely be many creative solutions that have yet to be developed, and therefore this will certainly be an exciting area of development for the space over the coming years.
References:
- DeFi Llama Lending TVL Rankings
- Introducing TrueFi, the DeFi Protocol for Uncollateralized Lending
- Mars Protocol Litepaper 1.0
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