DeFi (decentralized finance) is stuck to the good old path of collateralized loans. Collateralized loans have been popular in our financial system from time immemorial. But, it probably is time to look beyond this, towards uncollateralized lending.
The uncollateralized loan is not completely new to DeFi, but it’s not a feasible solution and it cannot replace collateralized lending, writes Frida Ghitis.
TrueFi is DeFi’s leading protocol, and has originated over $220 million of collateral-free, on-chain loans.
Fintech journalist. My works are featured by Cointelegraph, Investing, SeekingAlpha.
Collateralized loans have been popular in our financial system from time immemorial.
Taking loans against property, gold, and fixed deposits has been and still is the easiest way of obtaining loans in the traditional setup. But there is an obvious problem with this.
People with no collateral or credit score have little to no chance of getting access to loans. If we speak of DeFi (decentralized finance), we discuss that it has brought about a paradigm shift in almost every aspect of the financial ecosystem.
By making assets purely digital and transactions trustless and permissionless, DeFi has been able to take the financial ecosystem to places it has never been before. When it comes to lending, however, DeFi is stuck to the good old path of collateralized loans.
The Collateral Problem
In the early days of DeFi, lending had two types — collateralized loans and peer-to-peer lending.
Peer-to-peer lending took off initially as it eliminated the need for including intermediaries. The trend died down eventually as there was no way of enforcing repayment or procuring interest. Collateralized loans, on the other hand, prospered.
The simple process of locking up crypto assets equivalent to the borrowed capital became quite popular and lending protocols emerged everywhere. But crypto assets are volatile in nature.
If the value of the borrowed asset appreciates or that of the collateralized asset falls beyond the collateralization ratio, the loan is automatically liquidated and repaid without the interest accumulated.
This means a huge loss for lenders who were counting on the interest.
To partially circumvent this problem, over-collateralized loans became popular. It is a process where the value of the locked crypto-asset exceeds the value of the borrowed capital by a margin.
So, the borrowers have to put in much more than they need to cover for the volatility of the asset. But even this does not fully eliminate the liquidation of a loan beforehand.
Despite these flaws, the uncollateralized lending scenario has continued to flourish. But, it probably is time to look beyond this, towards uncollateralized loans.
Can Uncollateralized Loans be the Solution?
Uncollateralized loans are not completely new to DeFi. The idea has been toyed with for quite some time now.
Aave’s flash loans are a good example of uncollateralized loans. Here, borrowers can borrow loans without collateral, but the borrower must repay the amount within the same transaction’s time frame.
This is a very short-term loan that is only suitable to leverage opportunities like arbitrage, but it’s not a feasible solution and it cannot replace collateralized lending.
Then there’s TrustToken’s dedicated uncollateralized lending protocol, TrueFi.
Developed by the makers of some of the most popular stable coins like TUSD, TrueFi is DeFi’s leading protocol for uncollateralized lending. The platform launched in November 2020 and has since originated over $220 million of collateral-free, on-chain loans — with no defaults to date.
TrueFi takes a new approach to borrowing by blending on-chain and off-chain data (like trading history or company assets under management, respectively), as part of the world’s first crypto credit model, while also relying on community buy-in, letting TRU token holders vote to approve new borrowers.
All lending and borrowing transactions on the platform are fully transparent creating a layer of trust between the lenders and borrowers. Lenders on the platform add assets into the TrueFi lending pool to provide liquidity for lending.
Borrowers complete a rigorous onboarding and, once approved by TRU holders, submit loans under the terms of their credit limit.
The credit limit is decided by the creditworthiness (0 to 255) score given to borrowers based on their history and credit metrics. Borrowers must return the full principal along with interest before the term expires and every successful repayment increases their credit limit.
This new approach of allowing the community to decide on loan requests has some clear advantages.
Firstly, borrowers on this platform are provided with predictable loans that maximize their capital efficiency. The need for collateral is effectively eliminated with all risk parameters being pre-assessed by the community. And finally, lenders have a fool-proof way of generating stable, high yields, that rival those of secured lending.
The Way Forward
With a robust mechanism for borrowing and lending, TrueFi brings to DeFi as the most practical implementation of uncollateralized loans.
The platform not only makes it easier for borrowers to obtain loans but also eliminates some of the fundamental flaws of collateralized lending.
Given the success of this platform, it is safe to say users are leaning towards uncollateralized loans.
It will only be a matter of time before we see more such protocols emerging with their own way of securing uncollateralized loans. If the trend continues, uncollateralized loans could be the way forward in DeFi.
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