Borrowing Without Collateral: How Crypto Can Finally Create Credit


By Rafael Cosman, co-founder and CEO of TrustToken

If you’ve been paying attention to the DeFi industry, you’ll have noticed the emergence of bold new ‘unsecured’ lending protocols, or lending platforms without any collateral requirements that serve to maximize capital efficiency for borrowers. . Such lending methods, if perfected by blockchain, have the potential to chain the $ 11 trillion credit industry.

In the early days of finance, collateral was used as a valuable insurance plan for lenders, securing loans through assets to offset the risk of default. In DeFi, secured loans have served as the backbone of open lending protocols in the absence of viable alternatives. Since encryption protocols often aim to be completely untrustworthy, they often require more-collateral.

For example, in many cases, loans on MakerDAO must be guaranteed at 150% of the value of the borrowed assets. This gives MakerDAO strong protection in the event of a fault.

A proliferation of stranded collateral dampens market potential because it ties up otherwise useful capital to manage counterparty risk. Large-scale collateral traps can have serious consequences for the economy, as was the case with insurance-related securities after Hurricane Irma in 2017.

By overhauling and reducing collateral requirements, the system not only becomes more attractive overall to borrowers, but it can also prevent a significant amount of capital from being blocked unproductively. When borrowers have more access to funds that can be invested in the system, the market is more active and able to grow.

In order for the lending ecosystem to mature, the one thing that most experts really agree on is the need to overcome the problem of over-collateralization. And as DeFi continues its impressive trajectory, the almost limitless versatility of the Ethereum protocol has enabled innovative new alternatives to secured loans.

The era without guarantee

Unsecured loans represent a significant change in lending, which so far has focused on only one of the traditional “five Cs” of secured credit. While flash loans – that is, very short-term unsecured loans, often made for seconds or minutes at a time – have certainly caught the attention of cryptocurrencies, unsecured loans exploit increasingly dynamic answers to the loan approval conundrum. Industry watchers were initially optimistic but skeptical of how chain loans could truly maintain unsecured integrity, but the continued growth of unsecured protocols in 2021 has started to win over skeptics.

The first partial step towards unsecured loans was Aave’s credit delegation product, which allows one user to “delegate” their collateral to another, and a borrower to lend more than their collateral would normally cover. This format is effectively semi-guaranteed, because the borrower uses someone else collateral to contract the loan. But on the protocol side, the loan is still for the most part over-guaranteed, because if the borrower defaults, all the collateral risks being liquidated.

What is now taking shape is a series of emerging, insecure protocols, many of which mix governance with a mix of on-chain and off-chain credit data. These models impose things like loan terms and risk tolerance on each group of loans, while putting the power to vote on new borrowers and loans in the hands of token holders.

Unsecured credit is constantly being refined to improve its service and versatility in the credit ecosystem. Now, as new lines of business for unsecured loans in DeFi begin to take shape, future on-chain borrowers will be eligible for a loan based on a composition of the five Cs: not just the terms of the guarantee or loan, but also the character of the borrower (based on loan history), capacity based on the borrower’s debt-to-income ratio and the amount of capital the borrower has.

By establishing a pool of approved investors with a vested interest in the success of the protocol, unsecured lending protocols engage their community of users and token holders to determine the protocol’s risk appetite. Whether relying on expert delegates, a black box-style credit model, or the wisdom of the crowd, assessing the creditworthiness of borrowers and individual loans will be key to the success of credit protocols. unsecured loan in the future.

In the event of default, providing a real incentive for a trusted group of high quality investors to approve loans wisely and invest accordingly will be a key ingredient in galvanizing unsecured loans. Protocols that have a strong framework for enforcing measures against delinquent loans will further accelerate the abandonment of secured loans.

“Looking back, it was inevitable …”

Asked about Tesla’s adoption of Bitcoin (before it backtracked), Elon Musk said that “In retrospect, it was inevitable.” The same could be said of the prevalence of unsecured loans. The writing has been on the wall for some time: Everything from college loans and hospital bills to tax deferred and credit cards is no longer guaranteed.

The lending ecosystem just needed the right technology, the right circumstances, and the right momentum for the inevitable unsecured loan revolution to finally materialize. Now that it is on the rise, collateral will slowly but surely become one of the many factors in the credit equation.

About Rafael Cosman

Rafael Cosman is the co-founder and CEO of TrustToken, creators of TUSD and other TrueCurrencies, and TrueFi, the leading unsecured lending protocol.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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