Traditional financial institutions generally enjoy a degree of leverage over the average debtor, with banks often dictating the terms under which its credit facilities are offered. This has given rise to the alternative lending industry, with non-bank entities offering peer-to-peer (P2P) lending, equity crowdfunding, microfinancing, invoice trading, and balance sheet-lending. Nonetheless, the alternative lending industry is generally fragmented in nature as it lacks a coherent framework and is limited in scope, as it is mainly available to Micro, Small, and Medium-sized Enterprises (MSMEs) and startups. That is, until Decentralized Finance (DeFi).
As the name suggests, DeFi offers an alternative to the existing global financial system in the form of a decentralized financial system constructed on top of public blockchain networks, such as those of Bitcoin and Ethereum. Let’s explore the existing operating models of three major decentralized credit platforms in the DeFi market and their advantages over traditional finance.
First, we have MakerDAO, which operates using a pegged stablecoin model. Ether (ETH) holders can use their tokens as collateral in order to mint the DAI stablecoin, whose value is pegged to the US dollar. The advantage of this model is that pegging the token to fiat money grants a certain degree of stability and integrity to the lending and borrowing platform.
The second model is the money market model used by Compound, whose protocol involves linking each market to a particular token. The tokens function as intermediaries for credit facilities offered through the markets. Lenders in the markets can earn compound interest as calculated based on the supply and demand mechanism. The advantage of this model is that it provides for self-adjusting interest rates as determined by market conditions. Put another way, the market itself imposes interest rates as appropriate.
The third and final model is that of the Dharma platform, which essentially acts as a facilitator by matching offers and requests for lending and borrowing transactions. Interest rates are determined by the operator through a black-box process, whereby no discount is available for early repayment. This model does not offer much of an advantage, except in its simplicity.
Regardless of the operational model being used, borrowers certainly stand to gain from the use of decentralized credit facilities, as opposed to the use of conventional bank loans.
A major mechanism of traditional finance is the credit score, a measure of creditworthiness. Under the DeFi framework, however, borrowers would no longer have to worry about their credit scores, as generally, only the ownership of crypto-assets accepted by the decentralized credit platform for use as collateral would be sufficient. For example, Nexo offers loans in more than 45 fiat currencies, for which a borrower’s credit history is not a material factor. The only requirement is that the borrowers own the crypto-assets being used as collateral.
Then there’s the matter of interest rates. Borrowers on DeFi platforms are free from the imposition of interest rates unilaterally and opaquely set by banks. In contrast, the interest rates charged by peer-to-peer (P2P) blockchain-based lending and borrowing platforms are determined by the market participants themselves, providing a greater element of consensual free will to the transaction. Additionally, the use of over-collateralization with crypto-assets would most likely lead to decentralized credit platforms requiring reduced interest rates compared to those of traditional banks.
In the first half of 2019, the top 1,000 banks in the world bagged a combined US$1.135 trillion in profits — over 10 times the amount achieved a decade ago in 2009. As traditional banking institutions continue to take an ever-increasing piece of the pie, perhaps the shift to Decentralized Finance is not only preferable, but necessary.
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