DeFi’s pawnshop, Jack Ma’s handle

How far is the DeFi credit era?

"The essence of finance is credit. We must change the pawnshop mentality of finance and rely on the credit system for development. Today's banks still have the pawnshop mentality. Mortgages and guarantees are pawnshops, but the mechanism of relying solely on asset mortgages will go to extremes. Some companies have to mortgage all their assets, which puts enormous pressure on them ."

"The pawnshop mentality of mortgages is difficult to support the future world's demand for finance. It must be replaced by a credit system based on big data, so that credit equals wealth."

On October 24, Jack Ma, founder of Alibaba Group, delivered a speech at the second Bund Financial Summit which not only stirred up a huge uproar in public opinion, but also accelerated the pace of supervision to a certain extent, thus destroying the dream of wealth freedom for many Ant Group employees.

Although Jack Ma criticized the "pawnshop mentality", the fact that pawnshops have continued for thousands of years has been proven to be an effective model.

With the advent of blockchain technology, DeFi, which runs on code without permission, has given the "manual pawnshop" a new look and turned it into an automated pawnshop.

DeFi lending, the core of old finance, is dressed in the guise of a new pawnshop. This is also the inherent defect of DeFi - the lack of a credit system.

Can DeFi enter the credit era?

DeFi: Old Finance, New Pawnshop

Pawnbroking is one of the oldest industries in human society. It has existed as long as there has been money .

In China, pawning has existed for 2,000 to 3,000 years. The earliest name for pawning was “zhi”. In the “Shuowen Jiezi” of the Eastern Han Dynasty, the explanation of “zhi” was “to use things as a burden”, and the explanation of “zhui” was “to use things as money”.

Pawnshops originated from temple operations in the Southern Dynasties. Their main purpose was to help poor people overcome difficulties. Clothes, crops, utensils, etc. were used as collateral to exchange for goods, and the interest rates were relatively low and appropriate.

Despite years of social changes, the pawnshop model still dominates the lending market for a long time. Modern banking has begun to price credit , but it still prefers asset-backed loans, the core purpose of which is to minimize the risk of default.

If traditional financial loans dominated by the "pawnshop mentality" are called old finance, then DeFi is undoubtedly still the core of old finance, dressed in the guise of a new pawnshop.

The biggest feature of DeFi is actually decentralization, no need for permission, lower service costs and higher efficiency.

DeFi lending can be generally understood as an automated pawnshop that does not require an intermediary. Borrowers and lenders use smart contracts to conduct transactions.

The most typical example is that MakerDAO is a pawn shop.

Pledge Ethereum to the MakerDAO Collateralized Debt Position (CDP), and the smart contract will automatically generate a stablecoin Dai loan based on the over-collateralization rules.

Since it is the pawnshop mentality of "mortgage lending", in Jack Ma's eyes, DeFi is also a vassal of old finance and needs to be improved.

“We must get rid of the pawnshop mentality of finance and rely on the credit system.”

Jack Ma's words immediately put the entire traditional financial industry in opposition.

The credit era is inseparable from Financial Technology (FinTech), which uses machine learning and artificial intelligence to perform data analysis and thus price credit. This is also the guise for companies such as Ant Group and JD Digits to seek high valuations.

Jack Ma has the confidence to publicly criticize the "pawnshop model" that has lasted for thousands of years. The reason behind his bold statement is the huge success of Ant Financial's unsecured lending.

The non-performing loan ratio of Ant Financial Services Group was 1.31% in 2019, significantly lower than the overall non-performing loan ratio of listed banks in 2019. The overall non-performing loan ratio of rural commercial banks was 3.90% during the same period.
In 2019, the return on assets (ROA) and return on equity (ROE) of MyBank were 19bp and 3.45 percentage points higher than those of listed banks as a whole.

In the official propaganda language, this is certainly a success of financial technology, but is it really the case? Why are only Alibaba and Tencent's financial technology credit growing into giants?

Jack Ma’s grip

In credit risk control, two main factors are considered: Is there the ability to repay? Is there the willingness to repay?

Although financial technology boasts about using data from hundreds of dimensions for model analysis, in the field of credit, it still only solves one problem: measuring repayment ability.

The willingness to repay not only takes into account the game of interests, but also tests human nature. Whether it is a traditional bank or an online loan under the guise of financial technology, the post-loan risk management is similar: credit investigation, collection, and legal proceedings.

Unlike ordinary Internet financial companies, Tencent and Ant Financial have more powerful risk control measures.

Liu Bo, who has worked in Ant Financial and Xinwang Bank for many years, once expressed a view that although the success of Ant Financial's Huabei and MyBank benefited from big data, what is more important is their hooks: Alipay and Taobao stores.

"If you don't repay the 3,000 yuan loan (and the interest rate is not too high), you may have to pay a price. For example, you may no longer be able to use Alipay or Taobao, etc. Tencent's WeBank is also a similar tool."

"The credit of Taobao loans only depends on how much sales and profits I bring to the merchants. Ensuring that your credit limit is less than the default cost can ensure the safety of the loan. I can help you earn 100,000 yuan and give you a loan of 80,000 yuan. If you don't pay it back, the 100,000 yuan profit will be gone, and your store will be gone. Will you pay it back or not? What's more, all your sales are on Alipay, and all your customers are on Taobao and Tmall. The essence of the risk control logic of Taobao and Tmall loans is store pledge loans."

Tencent’s thinking is similar. The initial whitelist customers of Weilidai come from the relationship chain of Tencent and identified high-quality corporate employees. The social relationship chain is the starting point of Tencent’s financial credit.

Many Internet companies have massive amounts of behavioral data and powerful analytical computing capabilities, but they do not have the leverage of Alibaba and Tencent . Therefore, the ultimate risk control still has to resort to debt collection or legal proceedings, and it is difficult for credit to achieve similar scale expansion.

When Alipay and WeChat become the infrastructure of everyone's daily life, they become the best risk control tools. The logic of Internet companies such as Meituan and Didi in providing financial services is similar.

DeFi lacks credit leverage

From the above, it is not difficult to see the shortcomings of DeFi - lack of a credit system and no handle.

Today, DeFi lending is still a relatively closed system that can only use assets to create credit, but not credit to create assets. For most DeFi projects, the behavior path is still to lock liquidity to obtain new liquidity, making DeFi a shrinking market.

Under the anonymous blockchain system, it is impossible to measure a person's repayment ability through past data, let alone understand the willingness to repay . More importantly, there is a lack of means to enforce debt repayment. If there is a default, there is no way to conduct offline liquidation and get the assets back, and even legal proceedings cannot be the last resort.

In the long run, DeFi lending can only serve as a "new pawnshop". The prosperity of the pawnshop requires the expansion of underlying pledged assets or the full utilization of funds. At present, there are two main ways:

First, Bitcoin is transferred to smart contract networks such as Ethereum on a larger scale.

Bitcoin's market value accounts for 63% of the entire cryptocurrency market, but because there are no smart contracts, participating in DeFi lending requires cross-chain to networks such as Ethereum.

How to cross-chain? There are centralized custody solutions , such as wBTC and imBTC; there are also more decentralized cross-chain solutions , such as tBTC (Keep Network), renBTC (Ren) and pBTC (ptokens).

According to OKLink data, as of November 9, the circulation of bitcoins anchored on Ethereum was approximately 150,900. The top three are WBTC (123,410), accounting for 81.77%; renBTC (19,177), accounting for 12.80%; and HBTC (6,010), accounting for 3.98%.

Bitcoin's migration journey will continue.

2. Credit authorization.

Many deposit users deposited assets in the lending agreement but did not take out loans, which resulted in a large amount of locked assets in the lending agreement not being utilized and the credit line being idle .

In order to improve the efficiency of fund use, the lending protocol Aave has launched a credit authorization function , which means that deposit users with idle lending capacity can authorize their credit lines to people they trust, thereby earning additional income.

For example, Mike deposited a sum of money in Aave, obtained the corresponding credit line, and authorized his credit line to Jane. Then Jane's loan is endorsed by Mike's deposit. She does not need to provide assets as collateral, but she needs to pay an additional interest to Mike.

How does DeFi embrace credit?

So, does DeFi have the opportunity to enter the credit era and have on-chain credit loans?

As mentioned earlier, the two major hurdles facing lending platforms are the credit reporting system and the repayment system.

On the credit reporting side, either we build a credit reporting system belonging to the crypto world from scratch, track and analyze all transactions, loans, and financial management behaviors of wallet addresses, and quantify the data, but the premise is that DEX prospers and DeFi becomes mainstream.

Another way is to obtain credit data from outside the chain.

In the current concept, the intersection of traditional and new finance is called open finance.

Teller Finance, headquartered in San Francisco, is attempting to connect the data of traditional credit institutions with the DeFi ecosystem.

Individuals will be able to pull transaction data from their bank’s API and import it into the Teller Finance platform, running an open source algorithm to verify credit, while also bringing in traditional credit bureaus and sources of income information verification.

Based on the risk parameters involved, the Teller platform will calculate different credit limits and risk parameters to monitor the user's cash flow, account balance, legal authority, etc., and verify the user's repayment possibility.

Compared with the credit reporting side, the real challenge lies in how to build an effective repayment system, which inevitably requires breaking the anonymous system. DeFi needs a handle to connect the world.

In Teller's product design, they initially ask users to agree that if individuals fail to pay on time, they should agree to allow regional collection companies to contact them. The debt collection process is consistent with the traditional financial industry's method of collecting bad debts. However, in this way, they are consistent with traditional credit thinking and have no advantages. Teller's exploration has its positive aspects, but it is generally a bit idealistic.

Lending Club, the originator of P2P, will shut down its P2P business at the end of this year. The high level of non-performing loan debt has made global credit face the dilemma of "difficult collection" . Not all companies have the leverage like Tencent and Ant.

Therefore, there is another view that DeFi does not need to introduce credit at all, and should always remain anonymous and act as a pawnshop.

Li Feng, an analyst at TechFlow, also believes that credit loans are not an advantage of DeFi. If credit is forcibly introduced, the final result may be the same as most P2Ps, which will end in a crash. "Just be a pawnshop and wait for Bitcoin to cross the chain on a large scale, or for real assets to be mapped to the chain."

“DeFi should not be forced to cater to the real world, but the real world should actively embrace DeFi,” said an investor.