Defi aims to decentralize the financial markets using Blockchain technology. Most of this activity now exists on the Ethereum blockchain. Smart contracts now enable open to all permission less censorship resistant financial markets.
In this article we will be talking about the current state of under collateralized lending in the space of DeFi and various such protocols which allow that.
As we know mostly all of the DeFi lending borrowing protocols are over collateralized .Money markets like AAVE , Compound do not allow for under collateralized loans as risks of default increases.Protocols like Liquity allow for upto a collateralization ratio of 110 % with stands of risk of instant liquidations given the market volatility . But over collateralized loans stand as a major barrier in adoption of DeFi.
Under collateralized lending has been a holy grail in DeFi space because of key challenge of evaluation of creditworthiness in a decentralized manner and pseudo anonymity .
There has been quite a progress in this area in past 12 months .Below are some protocols which attempt to solve creditworthiness problem.
There are currently 7 solutions
- On-chain crypto native Credit scores
- Personal-network loans
- Flash loans
- Using NFTs as collateral
- Off-chain credit data integration
- Real-world asset collateral loans
- Third party risk assessments
i) Flash loans
Flash loans are uncollateralized loans in which the borrowed amount has to repaid within the same transaction if the borrower fails to repay , the transaction is reverted.This kind of loans are not suitable for long term borrowing but are useful for arbitrage traders and collateral swaps in crypto native money market.
Protocols : AAVE , DYDX.
ii)Third-party assessments
This introduces a third party to assess the creditworthiness of borrowers thus distributing the default risks.These third-parties are needed to stake some initial liquidity in cases of defaults.
Protocols:Maple Finance , Goldfinch.
iii)ON-Chain credit scores
Perhaps the most important and suitable solution to the problem.It involves assessment of previous on-chain activities of borrowers(loan repayment , yield farming , holding periods etc.)
Here the most important challenge is use of new wallets by defaulters.This risk can be mitigated by ZKPs (Zero-Knowledge proofs) and mandatory single wallet identity.
Protocols: KUDO money , ArcX money ,Ledger Score .
iv) Off-chain credit data integration
Since on-chain data is limited, this approach focuses on using Tradfi data to assess the creditworthiness.But this solution is unsustainable in long term particularly for crypto native users and also the pseudo anonymity thesis.
Protocols: useteller.
v) Personal Network Bootstrapping / Credit Delegation(CD)
Depositors have to approve the borrowing power which can be based on off-chain legal agreements or on-chain smart contracts
Protocols-AAVE for CD , Akropolis .
vi)Real-World Assets
Real world assets represented as NFTs on chain can be used as collateral.Similar to mortgage loans in Tradfi but decentralized loan financing.
Protocols-RealT Platform X AAVE , openDAO.
vii) NFTs as collateral
Here liquid NFTs can be used as collateral but it will be a small niche as most of the NFTs will lose value as time passes.
Protocols: NFTfi.
Overall the space is really nascent and there may be a need to introduce off-chain agreements and highly trustworthy on-chain credit scores to make this work.
