With DeFi quickly becoming the primary driver behind Ethereum’s “Programmable Store of Value” proposition, it’s important to consider where the majority of Total Locked Value (TVL) is being stored.
Interestingly enough, 4 out of the top 5 players happen to be in the lending sector. These projects (Maker, Compound Finance, InstaDapp and Nuo Network) account for roughly 93% of TVL at the time writing according to DeFi Pulse.
In this article, we’ll be taking a look at why DeFi loans have become so popular while comparing the process to that of a traditional personal loan.
Introducing DeFi Loans
With applications such as Maker and Compound, any individual can take out a loan of any size without having to disclose their identity to a third party in a matter of minutes. Most commonly, DeFi lending providers issue loans in stablecoins such as DAI or USDC, with new platforms extending lending capabilities for more volatile currencies such as Ether (ETH), 0x (ZRX), Basic Attention Token (BAT) and Augur (REP).
In order to properly function, all loans are secured using cryptocurrencies as the underlying collateral. Thanks to the advent of smart contracts, users are now able to immediately pass the due diligence process simply by staking the assets in their wallet as a proxy.
So, How Does DeFi loans Work?
Using MakerDAO as a tutorial, let’s take a look at how obtaining a loan works.
Step 1: Send Ether (ETH) to your preferred Ethereum wallet (Metamask, Ledger Nano S or Trezor)
Step 2: Visit the Collateralized Debt Portal and connect to the wallet you sent your Ether to.
Step 3: Click the “Open CDP” button to review the amount of ETH you wish to post as collateral and the amount of DAI you want to mind.
Step 4: After reviewing the terms (described below), press “Collateralize & Generate” and boom! Your Ether has been posted as collateral in lieu of newly issued DAI!
What’s the Catch?
Now that you’ve minted DAI, it’s important to take note of what you need to be on the lookout for. Some useful terms to understand include:
Liquidation Price: The price at which your loan will be force liquidated, or “margin called”.
Liquidation Penalty: The mandatory fee that is paid if you are margin called. Penalties are charged as portion of existing collateral and are dynamically adjusted based on Maker governance decisions.
Collateralization Ratio: An indicator to see how leveraged your wallet is. It is recommended to maintain a ratio at least 50% above your forced liquidation to account for unexpected price swings.
Minimum Ratio: The ratio at which you will be force-liquidated, should your collateralization ratio fall below this ratio.
Stability Fee: A fee that needs to be paid in parallel with the DAI you borrowed to close your loan. As of writing, all stability fees must be paid in Maker’s native token MRK, with the expectation that these fees will be able to be paid in additional tokens in the future.
Now that you’re comfortable with your newly opened CDP, you’re free to do whatever you want! It’s important to note that MakerDAO is just one of the many services that allow you to take out
Now that you’re comfortable with your newly opened CDP, you’re free to do whatever you want! It’s important to note that MakerDAO is just one of the many services that allow you to take out a collateralized loan. As mentioned towards the top of this post, other services include Compound, Nuo Network and Dharma, all of which allow you to borrow other currencies such as Ether, USDC and WBTC. Similarly, these services allow for other currencies to act as the underlying collateral. Once a DeFi loan has been granted, some potential use-cases include:
- Earning interest by lending your assets via third-parties such as Compound and Nuo
- Purchasing additional assets as an extended form of margin trading
- Selling DAI to USD to pay for personal expenses
Where Can DeFi Lending be improved?
While the trustless nature of DeFi loans are certainly exciting, there remain significant barriers to entry for the average user. First and foremost, in order to obtain a DeFi loan, users must be well versed with both Metamask and secondary exchanges to purchase and transfer Ether to the wallet being used to obtain a loan.
While not mentioned above, it’s commonly known that most DeFi lending platforms require overcollaterization ratios generally resting around 1.5x of the desired loan amount. In other words, in order to take out a loan of $100 worth of DAI, you must stake $150 worth of ETH as collateral.
As a result, the current process automatically eliminates any individuals looking to obtain an unsecured loan with little to no disposable income.
Seeing as the assets being used as collateral are still extremely volatile, DeFi loans require a significant amount of risk tolerance. Combined with the fact that issuance and stability fees are constantly changing (Maker’s stability fee increasing from 1% to 22% in the span of 4 months being a good example) it’s difficult to imagine any average user taking out a meaningful DeFi loan to help better their personal situation at this point in time.
With the cost of living in developed nations experiencing all-time highs, it’s no surprise that unsecured personal loans are quick to follow. In the first quarter of 2019, the TransUnion credit union estimated outstanding balances in the United States to be over $120 billion, more than 5x larger than the entire marketcap of Ethereum today.
Without diving too deep, the traditional lending systems classifies the majority of loans into three categories:
Secured – A loan backed by collateral (car, house, etc.)
Unsecured – A loan approved without any underlying collateral (personal/business)
Lines of Credit – A bank or merchant offering a specified amount of credit to an individual or corporation for an undetermined amount of time.
While different types of loans are often issued by specialized providers, the process of obtaining a loan in and of itself is generally the same across the board. Most commonly, loan providers will require individuals to provide a number of documents including but not limited to:
- Government ID (driver’s license or passport)
- Proof of income (paystub and/or bank statement)d
- Proof of residency (utility bill)
- Credit Score
- Social Security Number and/or Employee Identification Number
Taking this a step further, many loan providers often have restrictions related to who they will lend to, and the amount that individual will be able to obtain. Common restrictions include age, geographic location and minimum income thresholds.
All in all, the due diligence process has commonly been known to take anywhere from 2-5 business days with loans commonly being dispersed into the individuals account anywhere from 7-14 days after the initial request. Once approved for the loan, many providers will charge APR of between 5-20% with some providers taking out an origination fee on top of the initial disbursement.
DeFi Loan Conclusion
As of Q3 2018, the Federal Reserve Bank estimated the value of consumer loans, at all commercial banks, to be $1.49 trillion in the United States, alone (source). Compared to the $450M worth of loans issued through DeFi, the sky is truly the limit.
With DeFi loans requiring no proof of identity and instantaneous disbursements, there are clear advantages for techy savvy users looking to obtain additional capital. But, with the setbacks listed above, it’s safe to say that DeFi lending is current trustless at a cost.
Rest assured that with new features such as Compound v2 and Maker’s Multi-Collateral Dai (MC) rolling out in the coming year, industry leaders are doing everything in their power to make the improved lending process as intuitive as possible.
Until next time, be sure to stay up with all the latest information in DeFi by following our social media accounts below.
Cooper is a long-time blockchain enthusiast currently working as the managing director for Fitzner Blockchain Consulting. Starting his career in the industry as a project and community manager, Cooper has since expanded his skillset as a CFA Level 1 candidate and recent graduate of Draper’s Hero Training in San Mateo, California. His favorite DeFi projects include Set Protocol and Ren Project with a strong interest in The Block Crypto and Messari.