DeFi Insights: Understanding the Essence of DeFi Lending from Traditional Banking Business

When facing certain applications or businesses in DeFi, we seem to no longer be able to understand them using traditional thinking patterns, because many times the same two words are almost completely different things.

For example, the flash loan mentioned earlier, using the characteristics of blockchain technology, can still achieve zero-risk lending when the borrower has no credit and no collateral. In addition, the mainstream over-collateralized lending in DeFi is completely incomprehensible with normal thinking. Why should I use money to borrow money? Or more collateral and less borrowing, which is obviously not in line with common sense.

We can understand the essence of DeFi lending business at the current stage from the differences in traditional finance.

Lending business under the traditional commercial banking model

First of all, the main business modules of traditional commercial banks are divided into three categories: asset business, liability business and intermediary business.

Asset and liability businesses are on-balance sheet businesses. Simply put, when an individual deposits money into a bank, the deposit is the bank's liability (the bank needs to respond to depositors' withdrawal requests). When a customer borrows money from a bank, the loan is the bank's asset (creditor's rights, the bank recovers the loan and interest when due).

The capital pool operation model is derived from the asset and liability business, which puts deposits from various channels into the capital pool, and then takes out funds from the capital pool to lend to loan customers. The capital pool model can maintain good operation by simply managing the surplus and loan risks in the capital pool. This is the most classic traditional financial lending business.

Among them, controlling loan risks is the most important part of the fund pool model. From the perspective of loan guarantee, it is divided into credit, guarantee and mortgage loans . Credit loans are based on the borrower's reputation and credit. Thanks to the construction of a big data credit system, the credit loan procedures are simpler than before. Although it is a credit loan, most borrowers who can obtain a credit limit have income and credit ability that can basically cover the bank's loan limit, and the risk is still within a controllable range. Guaranteed loans are loans made by customers through joint and several guarantee responsibilities through a third-party guarantor, and loans are made based on the credit or risk preference of the guarantor. Mortgage loans are loans from banks using their own property, such as houses, cars, land, etc., as repayment guarantees. In essence, it is to exchange assets that are not easy to flow into highly liquid assets such as money. Because banks have a low risk preference, mortgage loans still account for the highest proportion of all types of loans.

Lending and borrowing models in DeFi

At present, various lending platforms in DeFi are basically in the mortgage loan mode in terms of model, and are more inclined to the pawnshop model as a whole, turning various digital currencies into goods of fixed value, mortgaging goods worth 100 to obtain liquid currency worth 75. The behavior of obtaining currency through currency mortgage seems very stupid, but the high mortgage interest rates and huge yields in the early stage of the DeFi market have attracted higher market funds.

The main market demands for DeFi lending are as follows:

1. Meeting the funding needs of trading activities : including arbitrage, leverage, market making and other trading activities, which is the most important rigid demand. For example, over-the-counter service providers or market makers need to borrow funds to meet a large number of transactions. Traders increase leverage through borrowing, or borrow assets to short sell for arbitrage.

2. Obtain passive income: that is, investors who want to hold crypto assets for a long time and hope to generate additional income.

3. Meet the funding needs of token economic activities such as liquidity mining.

4. Obtain a certain amount of liquidity funds: This is mainly aimed at the short-term liquidity needs of miners or start-ups in some industries, which is more in line with the logic of traditional lending business.

But unlike traditional lending, which lends money to those who need it more, we see that DeFi lending is currently more of an arbitrage game where a user provides loan funds to the market, then borrows it out himself, and then uses the borrowed money for mortgage lending, and so on. This cycle seems silly, but users can get multiple benefits with one fund.

Compared with traditional RV mortgages, which require manpower to verify the asset owner, and repayment defaults require manpower and time to auction assets. The pawnshop model in DeFi only needs to stop the mortgage when the mortgage rate is too low and liquidate the assets to end the loan contract. Compared with traditional mortgages, the operating costs are extremely low, and the total amount of loans borrowed by pawnshop Maker in DeFi has exceeded US$900 million.

Several core issues that need attention

1. Is DeFi lending following the old path of private financial innovation?

A few years ago, peer-to-peer Internet finance was once regarded as a revolutionary product of financial innovation. Initially, peer-to-peer lending meant lending from person to person or institution to institution, pooling small amounts of money together to lend to borrowers in need of funds. However, centralized institutions were attracted by the high rate of return on the capital pool and started various shadow banking models, using illegal fundraising, CX and other models to turn the innovative concept of inclusive finance into a high-yield escape game. There is nothing wrong with peer-to-peer distributed finance in essence, but centralization and lack of transparency give institutions that use peer-to-peer Internet finance as a gimmick the opportunity to commit a lot of evil.

In DeFi lending, the platform itself is replaced by smart contracts. The platform cannot use any user's digital assets. All intermediate matching processes are replaced by smart contracts. At the same time, the over-collateralized liquidation model provides sufficient protection for depositors' funds, so that the platform does not have to worry about bad debt risks. If real assets or credit can be put on the chain one day in the future, the peer-to-peer model in DeFi will usher in a huge explosion.

2. Is the issuance of stablecoins by lending institutions a hold over core transactions?

In the real world, the division of labor among financial institutions is usually quite clear. The central bank is responsible for formulating monetary policy, maintaining financial stability, and resolving financial risks. Commercial banks are credit intermediaries and are responsible for deposits and loans, while pawnshops are responsible for mortgaging physical assets in exchange for highly liquid assets. Although centralized institutions are programmed in the blockchain market, operators in the commercial bank model or pawnshop model issue stablecoins by occupying the market and producing their own stablecoin tokens through lending with high returns. This has caused useless transaction friction in the market, so that if traders in the market want to conduct secondary transactions on assets obtained through mortgages, and the products traded do not support the stablecoins loaned by the borrower, they need to exchange the borrowed currency for the mainstream currency in the market for trading again, which adds a layer of transaction friction in vain and is of no benefit to the market.

3. Why has lending business become one of the three core areas of DeFi?

The essence of lending in DeFi is still to provide liquidity for the market, by mortgaging low-liquidity assets in exchange for high-liquidity assets, but the high LTV (pledge rate) in the market, but because the model of coin-to-coin mortgage is actually to obtain high-liquidity assets by mortgaging high-liquidity assets, and at the same time, the over-collateralization model reduces the liquid assets in the market. Therefore, the way of lending in the over-collateralization model alone is of no value to the market, but liquidity mining combined with the over-collateralization model breaks the problem of insufficient market liquidity, that is, the mortgage funds are used to provide liquidity, and the assets obtained by the mortgage are invested at the same time, using leverage to provide multiple liquidity for the market, and overall revitalizing the largest liquidity demander in the DeFi system, DEX (decentralized exchange).

Looking at the mainstream business direction of the current DeFi lending market from the perspective of leading projects

Compound (Peer-to-Peer Mode)

The decentralized peer-to-peer model is a good inclusive financial model for the market. Compound's fund pool utilization model enables the funds in the pool to achieve extremely high utilization value. At the same time, peer-to-peer plus over-collateralization allows borrowers to carry out endless capital circulation in the market (the fund pool will never be exhausted).

Compound perfectly describes a financial concept, that finance itself is not productive, and each participant is a liquidity carrier in the market.

Maker (Pawnshop Mode)

MakerDAO is one of the earliest DeFi protocols on the market. It issues loans through an over-collateralization model. Users obtain deposits and income from price fluctuations by pledging ETH or other cryptocurrencies accepted by the platform, and then reinvest through the loaned DAI. The over-collateralization model solves the problem that the funds of long-term investors in the market are always in a frozen state, and improves the utilization rate of funds to provide liquidity to the market.

The mortgage lending model is to mortgage low-liquidity assets to obtain high-liquidity currencies. In the DeFi market without a credit system, the method of using currency as collateral to obtain credit in exchange for currency seems simple and efficient, but the shrinking liquidity generated under the high pledge rate is not as simple for the market as increasing leverage.

Aave (Flash Loans)

Aave's flash loan is the first unsecured lending model in the blockchain world. It has a pioneering spirit and utilizes the unique characteristics of the blockchain to make itself risk-free. The design of the flash loan utilizes the characteristic of Ethereum's block generation of more than 13 seconds, temporarily transfers the loan funds to the smart contract, and executes the transaction operations designed by the developer. If the funds and fees are confirmed to be returned to the fund pool, the operation is executed successfully. If the returned funds are less than the lent funds, the transaction is restored, so that the transaction maker and the depositor can achieve the nature of an unsecured loan without any risk.

Because the unique feature of flash loans is to use the price deviation in the market for arbitrage operations, which makes large-scale arbitrage in the market continue. In essence, arbitrage transactions in financial products are one of the normal operating methods. However, the large amount of funds in flash loans and the simplicity of high-frequency arbitrage amplify the arbitrage risk in the market. In the digital currency market, as long as the arbitrage space is sufficient to cover the transaction costs, there will be news about arbitrage using flash loans. However, flash loans are still benign to the digital currency market in the long run by smoothing the market price difference and promoting reasonable market pricing.

Flash loans have also attracted enough traffic for Aave. Compared with other platforms, what makes it unique is that users can freely choose between stable and floating interest rates for loans, which can minimize the borrowing costs incurred by borrowing. At the same time, the high deposit interest rate has also attracted many users to Aave.

What is missing from current DeFi lending?

We can see that there is no credit lending in the current DeFi lending market. Credit lending is obviously a more efficient model than mortgage lending, but it is a huge challenge to build a basic system for credit lending in the anonymous environment of the blockchain. First of all, we need a highly recognized and reliable credit system to judge the repayment ability of borrowers, so as to control the risk of bad debts. Whether we use oracles to introduce a large credit database in the real world or establish a credit mechanism within DeFi, these are not the key. The key point is how to make a bound individual and the corresponding credit, that is, a person has multiple accounts, some with excellent credit and some with extremely poor credit, then the account with poor credit will bury a huge bad debt risk for the lending market. In addition, if credit is obtained through reality, the original intention of anonymity in the blockchain system is meaningless.

Under the strong anonymity system of blockchain, seeking credit support is itself a breakthrough in a weak point. Instead of taking the challenge of finding anonymous credit in an anonymous market, it is better to improve capital utilization through user operating habits, reduce LTV (pledge rate), and reduce the problem of reduced liquidity caused by a shrinking market.