This research will explore uncollateralized lending and its potentially damaging impact on the crypto markets. We will look at uncollateralized lending and some approaches that exist today. Finally, we will outline ways in which the system can have a damaging impact on the overall markets.
Collateralized lending in crypto refers to a type of loan that permits investors to lend their cryptocurrencies to different borrowers and receive yield for doing so. Many platforms that allow crypto lending and borrowing accept stablecoins and crypto tokens as collateral. A crypto loan allows traders and speculators to receive liquid funds without selling their cryptocurrency. The types of loans are custodial crypto (CeFi) loans and Non-custodial (DeFI) crypto loans.
Centralized custodial finance (CeFi) loans, just as their name suggests, are custodial and centralized. A central entity takes custody of collateral. In this situation, a trader cannot access their collateralized assets; the lender controls the assets’ private keys. Around 80 percent of crypto loans are currently custodial (5/2022). Non-custodial (DeFI) crypto loans, on the other hand, are non-custodial. These loans depend on smart contracts. If a trader takes out a DeFi loan, the trader remains in control of their private keys.
Uncollateralized loans, also known as unsecured debt, are a form of credit given to those considered trustworthy. In the traditional finance markets, uncollateralized loans are usually issued by large banks and given out to individuals and businesses based on prior credit or proof of future income. In crypto, uncollateralized lending is more complex. The protocols attempting to solve this problem use different ways to validate if the user is trustworthy enough to receive funds.
The first protocol we will discuss is Truefi. Truefi allows lenders to add assets into a TrueFi lending pool, for which lenders earn interest and TRU tokens. Any unused capital is sent into the Curve.fi protocol to boost earnings. Currently, borrowing is reserved for institutions rather than retail; they are whitelisted through a process that involves a thorough review of their business, the signing of a lending agreement, and the TRU community’s approval. Borrowers, once approved, submit a request for capital at an interest rate and credit limit determined by their credit score, which is subject to TRU community approval, who signal their opinion on the loan by voting. The Borrower must return the principal and interest on or before the term expires. Delinquent borrowers will face legal action under the loan agreement signed during onboarding.
Another approach to uncollateralized lending is Union protocol. They allow any address on the Ethereum network to accumulate a credit line on-chain in a permission-less crypto-native way. The protocol does not underwrite risk. It remains a neutral party, providing a mechanism for one or more addresses to “vouch” for another address. This allows a “network of trust” to form around an address, which is used as a signal for the user’s creditworthiness to a potential lending party.
Another big player in the space is Maple Finance. Maple Finance is an on-chain decentralized undercollateralized credit market. They offer loans to companies with strong balance sheets through KYC-AML credit checks and legal agreements with a minimum borrowing requirement of 1M. Maple allows anyone to provide liquidity but has borrower requirements. Lenders deposit capital in lending pools that are managed by pool delegates. Lenders are rewarded in interest and Maples native MLP token.
Atlendis Protocol approaches uncollateralized lending through whitelisting trusted dApps and protocols. The protocol uses a specific liquidity pool per Borrower. Borrowers have access to loans via a bid order book. Interest and principal on the crypto loans are repaid at maturity. Borrowers pay a liquidity fee on unused capital and interest fees on used capital. An exciting application here is once a lender chooses a borrower, an NFT is generated on-chain that represents the parameters of the agreement. The NFTs are equipped with distinct artwork. In addition, the NFT displays information about the deal that can be viewed on-chain at any time. Each NFT can be sold to another person who then assumes the interest payments.
As it stands, there are many problems with under and uncollateralized lending in crypto. The first is the worthiness of the assets used for the loan in the undercollateralized case. As the time horizon of a loan increases, most crypto products will face a price decrease due to intrinsic volatility, which can cause a default on loan. Demand for lending is directly correlated to market fluctuations and can cause greater volatility in the market. Outside of stablecoins, most collateral assets in DeFi are correlated to one another. Lending protocols revenue is directly tied to the demand for leverage. Periods of higher demand for leverage correlate to more revenue for the protocols and similarly for periods of less demand for leverage. Since investors, speculators, and traders are using borrowed funds to invest in other correlated assets, if a sharp drop in the market happens, there is an increased risk of liquidation spread across multiple protocols due to the utilization of borrowed funds in different networks.
Protocols require heavy short-term incentives to attract capital. Currently, borrowing and lending platforms are all fighting for the same fixed number of potential tokens as collateral due to the price stability of these tokens. Capital flows to the system providing the highest rewards for users regardless if the long-term reward model is sustainable. The outcome of this is protocol capital or value being lost through inflationary token rewards or reduced profit margins. If a protocol isn’t finding ways to attract mercenary capital, it most likely will not survive.
Problems with collateralized and uncollateralized lending are the correlation between market fluctuations and demand for lending and the incentives offered to attract capital. Further, the possibility for someone to escape and not abide by the loan agreement is another sizable risk that arises with uncollateralized lending. Downturns in the market can cause users to go below their initial loan and default. A market downturn paired with a default makes it harder for the protocol to pay back the pool. In specific protocols, the excess capital is migrated to other protocols to boost earnings, but losses are exacerbated if most market assets are correlated to a degree. I do not believe the risk of lending capital is adequately compensated on an uncollateralized platform vs. a collateralized one. Examples of collateralized platforms are Coinrabbit: 10% APY on usdt, Crypto.com up to 14% APY, and Nexo, with around 10% APY. Compared to TrueFi, one of the leading uncollateralized lending platforms, the highest interest earned on a stablecoin is 13.47% APY. Lending APY on Atlantis and Union protocol is variable.
For lending protocols to succeed, value must be captured long-term. One method of doing so is the ability to capture and hold collateral value, using new primitives such as loans secured by real-world assets (RWAs) and new decentralized stablecoins. The second method would be utilizing liquid staking derivatives (LDOs) to collateralize a loan, and the yield generated through staking could be used to begin paying off the loan or used to grow the size of the loan.
Another big risk faced by uncollateralized lenders is, of course default. Seen through Maple Finance’s 54M of bad debt and TrueFi’s 4M of bad debt. Uncollateralized lenders face big risks in default, and a market downturn or hack can expose them to default even further. How are uncollateralized lenders compensated for the increased risk faced during a market downturn?
Now within some structures of uncollateralized lending, there is a way to cheat the system. For Union Protocol, the address asking for the loan can offer monetary rewards for addresses vouching for them, allowing them to be paid out from the stolen funds. There are also many other methods to facilitate the vouching of an address for a loan. Atlandis Protocol and TrueFi have more strict requirements, mainly only permitting their lending platform to be used by institutions and trusted smart contracts. Still, these systems rely on trust. The trust that this institution or smart contract won't get hacked or become nefarious.
Much like in traditional finance, uncollateralized loans exist for those proven worthy of the funds. As the total value of uncollateralized lending will eventually grow, it is dangerous to allow a mass amount of uncollateralized money to be acquired. As was seen with over-leveraging in crypto markets during the flash crash of September 7, 2021, and May 19, 2021, leveraging is dangerous. Uncollateralized lending is a form of leverage where a loan is used to attempt to generate more alpha or earn greater rewards. With collateralization, the lenders have some form of recourse in default, whereas in uncollateralized, they must trust the Borrower that their funds and interest will be returned. I don't know about you, but my trust comes at a very high APY, at which point I question how the protocol will be able to return funds should clients liquidate or lose funds.