March 22, 2020

The future of decentralized finance (DeFi)

Taking out a loan on a DeFi platform today usually requires you to lock in more money than you take out. Does that mean that DeFi loans are forever doomed to fail? Or could a future infrastructure that is more integrated with the blockchain provide a benefit and solve this issue?

What is DeFi?

DeFi is a collection name for decentralized networks that aim to provide financial services. This includes dApps (decentralized applications), DEXes (decentralized exchanges) and decentralized insurance.

These services are essentially trying to improve the traditional financial systems by taking out the middle man and creating robust, censorship-resistant platforms.

For this post I’m going to focus on the lending platforms.

How lending works today

When lending money through DeFi there is no middleman. Instead, everything is handled with Smart Contracts.

The biggest network for lending platforms today is the Ethereum network. As of now, Ethereum has, by far, the biggest market cap amongst the cryptocurrencies with smart contract technology. Therefore, it is much easier to host a lending platform there since bigger loans can be made.

When lending money, usually the lender has to provide some sort of collateral. Typically they would deposit some cryptocurrency first in order to get the loan. Constant is a platform that offers these kinds of loans.

The benefit with these loans are that they don’t require you to interact with another person, you pay lower interest and the loan can be accepted in a matter of minutes.

Maker DAO: An example

The DAI stablecoin logo
The Maker logo

MakerDAO is the largest decentralized finance application on the Ethereum blockchain. It consists of DAI and MKR tokens.

To take out a loan in DAI, the lender has to open up a Collateralized Debt Position (CDP). This is done by depositing some sort of Ethereum based asset and lock it into the MakerDAO platform. These assets are typically the Ether token, but could be other assets such as, for example, Crypto kitties. What assets are acceptable are decided collectively by the MKR holders.

“A collateral asset is a digital asset that MKR holders have voted to accept into the Protocol.” – MakerDAO white paper

“One MKR token locked in a voting contract equals one vote.” – MakerDAO white paper

The lender can maximally take out 66% in DAI of the value of the locked in Ether. If the lender is unable to pay back, the CDP will be automatically liquidated on the market with a 13% penalty.

Adding real assets on the blockchain

The problem with DeFi lending today is that you typically have to lock in more money as collateral than you want to take out as a loan. But what could you do if you need to take out a bigger loan?

What if you had your house registered on the blockchain and could use it as collateral? What if the proof of ownership for your home, vehicle etc. was done on the blockchain? If all of it was tokenized it wouldn’t be hard to include as collateral in a smart contract.

This is of course a far fetched idea today. Registrations of vehicles and proof of ownerships aren’t stored on the blockchain today and probably isn’t going to be in the near future either. But if we get to a point where governments start seeing real value in putting it there, it will likely be hugely beneficial for the DeFi space.

Final

There are still a lot of unanswered questions in the DeFi lending space. Every new emerging disruptive technology has its struggles and DeFi is no different. But in my opinion it is a really exciting upcoming new market that can offer a lot of benefits compared to the traditional systems.


Further reading

https://makerdao.com/en/whitepaper/

https://defiprime.com

https://medium.com/instadapp/decentralized-loans-on-blockchain-ce4e0d266ed1

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