The Question of Underwriting in DeFi And What's Developing On That Front
So far 2020, has been a truly magnificent year for Decentralized Finance (DeFi). Since the beginning of the year, the total value locked in DeFi smart contracts has risen fivefold, with the vast majority of this growth coming from the last two months alone. This was also marked by the emergence and explosive growth of new hopeful DeFi platforms, such as Compound and yearn.finance.
However, there is still a long road ahead for DeFi to become a veritable alternative to traditional finance and one of the most pressing pain points right now is underwriting. In classical finance, taking out a loan means that you go to a bank, the bank assesses the probability of you being able to pay back the loan, and if the bank deems you creditworthy, you get your loan instantly, often without any collateral.
With DeFi, it is not the same. When you want to take out a loan, you have to provide a much larger amount of money as collateral than the amount you are getting.
Now, this does make sense if you take out a loan on an illiquid asset, for example, if you take out a mortgage on your house. Suppose you need some money to bridge over a minor financial emergency.
Sure, you could sell your house and use the revenue to pay your bills, but most of us would prefer to keep living in our own house. Instead, you can easily use your house as collateral to get a credit line from your bank.
In contrast, cryptocurrencies are highly liquid assets, so there is no real need to take out a mortgage on your crypto holdings.
Furthermore, there are instances where you need cash for spending, but you don’t want to liquidate your crypto because you expect the price of your assets to rise.
However, you are not really taking out a loan in the classical sense with DeFi, since you have to put down more capital as collateral than you are taking out, thereby increasing your risk exposure.
This is more akin to taking out a leveraged position than a loan. In fact, you are likely better off simply selling a share of your holdings and then taking out a leveraged position through either margin trading or perpetual contracts, since this is usually cheaper and liquidation risks can be estimated more easily.
In order to move forward and become attractive to a wider audience, DeFi must take this important step and make real underwriting possible. Here are three promising developments on the road to underwriting in DeFi.
Naturally, when you lend money and take on the risk that your counterparty defaults on their debts, you want to know the identity of your counterparty. With DeFi, borrowers could be literally anyone. This can only work since as a lender, that counterparty risk is mitigated by the fact that the loan is overcollateralized.
In order to enable underwriting, however, it is absolutely necessary to determine the borrower’s identity. Otherwise, the borrower could easily refuse to pay back their debt and get away with it.
When you know the identity of your counterparty, you can take legal action against them, which could result in the worst-case of personal insolvency for the borrower.