DeFi's Structural Weakness
DeFi has a structural weakness: Credit.
Without the ability to extend credit, demand for borrowing in DeFi is limited to a narrow set of crypto-native use cases where overcollateralization is an acceptable price to pay for access to funds.
There are two primary use cases for crypto borrowing today. Accessing liquidity or getting leverage.
Individual borrowers access liquidity by posting their crypto as collateral, borrowing stablecoins, and then converting those stablecoins to fiat. The APY on USD stablecoins is ~10%, which means this borrower is betting that their Ethereum will appreciate by over 10% per year. This borrower may also be using the loan in order to avoid selling their crypto, which would trigger a tax event, and therefore make the high APY an acceptable tradeoff regardless of how their collateral performs.
Individual and institutional borrowers use DeFi borrowing in order to get leverage on their arbitrage and near-term futures trades.
The demand for these loans is huge as evidenced by the $26B of capital currently locked in DeFi lending pools.
The global market cap for crypto is $1.3T so we have ~2% of that market cap contributed to lending pools which are only able to service borrowers on an overcollateralized basis. If we remove Bitcoin from these figures the story is even more compelling since bitcoin represents half of the crypto market cap but only ~10% of the DeFi lending TVL.
As long as the risk/reward of DeFi lending is favourable we will continue to see more capital chasing DeFi lending yields. DeFi front-ends and wallets will bring yield into the core of their experiences by automatically contributing to pools, and institutional investors will create new platforms to satisfy LPs that are looking for exposure to this emerging asset class. The supply side of this market is healthy and will continue to grow at least linearly with the overall crypto market.
On the demand side, DeFi lending has serviced a narrow set of needs very well and done so in a novel way by removing costly intermediaries while increasing speed and market transparency.
But for DeFi lending to grow exponentially from here we need to address the structural weakness on the demand side. Bringing credit into DeFi means any lending use case that exists off-chain can eventually be executed as a DeFi loan.
With protocols like Maple and Goldfinch, DeFi is entering a new phase of maturity and this will set the stage for an explosion of consumer demand for DeFi services.
To date, DeFi has been about the removal of unnecessarily high cost intermediaries and redistributing that value to network participants. Most of the demand for DeFi lending is coming from borrowers who are already active participants in the crypto economy. These users are crypto-rich and require new types of financial products that are not available through traditional banks.
With the introduction of credit, we are adding knowledge processes to DeFi. In traditional finance these knowledge processes are inefficient human coordination efforts such as reviewing credit history, asset appraisals, financial disclosures, and understanding the use of borrowed funds. In DeFi, these off-line knowledge processes can be coordinated more efficiently using incentives. This should result in lower risk, lower borrowing costs, and easier to use financial products.
Goldfinch (whitepaper)
Goldfinch works by creating senior and junior tranches, where Backers supply first-loss capital to the junior tranches at higher yields and Liquidity Providers supply capital at lower yields to the senior tranches.
In this model, Backers actively allocate capital by assessing specific lending pools. Whereas Liquidity Providers earn passive yield as allocated by the protocol.
Borrowers are approved by auditors, who “secure the protocol with a human eye”. Those auditors earn rewards in the protocol’s native token (GFI) according to their performance.
Borrowers are incentivized to repay loans because all of this activity is attributed to the borrower's public address, which acts as a credit history report for future borrowing.
You can imagine that as more real-world assets are tokenized we will see Backers able to secure their positions with access to recourse such as real-property or future income.
Maple (protocol overview)
Maple is a decentralized corporate credit market. It’s primary borrowers are institutional actors seeking leverage on their trading strategies.
The primary source of capital is Pool Delegates who are professional asset managers that conduct due diligence on borrowers and fund loans.
Pool Delegates manage liquidity pools, which Liquidity Providers (the general public) can contribute to for passive yield generation. Unlike with Goldfinch’s Backers, it is unclear to me if Maple’s Pool Delegates must contribute a certain ratio of the total pool before the protocol allocates funds from Liquidity Providers.
These are the first of many protocols that will introduce decentralized knowledge processes on top of DeFi capital pools. Maple has only one active liquidity pool while Goldfinch claims to be servicing 10k+ borrowers in Mexico, Nigeria, and Southeast Asia.
Maple is targeting a market of crypto-native use cases that are currently serviced by centralized lending firms like Genesis, which is the largest crypto-lender in the World at $9B in outstanding loans.
Goldfinch is targeting retail borrowers in regions that are underserved by traditional lenders.
As these protocols mature and others are built in their image I expect to see an expansion in the number of borrowers that can access credit via DeFi. I also expect to see diligence processes optimized for speed and efficiency. Risk tolerance will grow as losses are absorbed by a much larger pool of successful repayments.
With the addition of credit, DeFi lending becomes a viable alternative to most traditional lending processes.
With this new capability, DeFi front-ends and wallets will push further into “primary bank” territory, meeting user demands in ways that traditional lenders cannot.
In the next post, I’ll cover the current landscape of wallets and front-ends, and why we are about to see an explosion in the number of these services.