Loss of interest: The flaws of DeFi loans and a plan to improve it

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By Brent Xu, CEO of Umee

When first theorized, decentralized finance (DeFi) promised to create autonomous systems that would be cheaper, faster, more efficient, and more accountable than financial systems of the past, facilitating greater participation in the financial ecosystem. Among the use cases DeFi envisioned was an enhanced lending system built on this organizing principle. However, this vision is far from being realized.

The problems with Status Quo DeFi loans

The ideal real-world lending applications first envisioned by DeFi evangelists have yet to materialize. Instead, seduced by the tantalizing prospects of easy profits and spectacular short-term gains, the crypto lending ecosystem has acted as if it were immune to the fundamentals that govern all debt markets. Rest assured, this is not the case, and periods of market stress like the one we are currently experiencing clearly show this.

The economy-wide market contagion being unleashed is seriously hurting two types of crypto lenders, the ponzinomic and the reckless. Ponzinomic lenders are those who bet at high risk on the discredited notion of perpetual exponential growth. For example, the Anchor protocol, which promised an annual percentage yield (APY) of 20% on the staked UST, had little financial or statistical basis to promise such a rate. It was based on unreasonable expectations of exponential demand and was clearly untenable.

Reckless lenders, many of whom promise to use complex arbitrage strategies, have carelessly turned to simple directional bets. In the case of Voyager, Three Arrows Capital and Celsius, these directional bets were – like those of the ponzinomic lenders – based on optimistic growth projections with little or no contingency planning.

Similar to the failed Web2 business concepts of the early 2000s dot-com bubble, none of these models are likely to survive the current bear market. Those of us with an eye to the future should start writing the rules for a DeFi 2.0 lending market – a lending market less about extracting maximum short-term gains and more about developing financial infrastructure based on real-world utility.

Why loans are important

Lending performs a vital societal function; sustaining the modern economy requires efficient resource allocation and scalable capital investment. Imagine a company looking to build a factory. Although the company may not have the capital to self-finance the construction, it knows that the long-term returns from such a facility will outweigh the short-term costs. Therefore, the business will take out a loan with an interest rate specifically calculated based on both the time value of money and the creditworthiness of the business in question. At present, this type of business lending takes place almost exclusively in the traditional financial realm.

How to Reform DeFi Lending

Decentralized loans cannot yet offer the same real-world investment utility because they lack the mechanisms to determine quantitatively derived interest rates. DeFi will not be able to scale beyond its limited – and unsustainable – use cases. To make this leap, we need to develop blockchain-native versions of the main facets of the bond market: the yield curve and credit/debt ratings.

The yield curve is considered by many to be a primary indicator of economic expectations. Therefore, its accuracy is extremely important for a number of applications. In the traditional financial sector, US Treasury debt forms the basis of the yield curve offering so-called risk-free rates for different maturities that ultimately reflect the time value of money.

Other borrowing and lending rates – from individual borrowers taking out a 30-year mortgage to public companies issuing 10-year corporate bonds to fund their operations – trade at a spread to the risk-free rate. which applies to these same durations.

No different from how traditional debt markets have operated for centuries, a functioning decentralized debt market will also require a risk-free yield curve that will form the basis for other borrowing and landing rates, staking or frankly wherever digital assets are risky in exchange for some return. Additionally, once a yield curve is established, developers can create additional features to assess borrowing risk profiles of specific blockchains – tools such as scoring mechanisms.

A global blockchain debt market

More importantly, ultimately, the influence of this decentralized yield curve will extend far beyond digital assets. Global debt markets, in their entirety, will migrate to blockchain. The benefits of enterprise-scale lending in a decentralized ecosystem are simply unmatched by the traditional lending market.

While traditional bank debt financing is bureaucratic, slow, and subject to complex decision-making and due diligence processes, decentralized lending works through self-executing smart contracts, which process loan applications quickly and objectively. In addition, smart contracts are less subject to the negative influence of human biases and biases. Ultimately, these efficiencies reduce the burden on borrowers and lenders and ease the frictions that can limit financial activity.

I am certain that companies, individuals and even governments will move towards debt trading on sovereign blockchains. However, systemic changes need to be made to the underlying industry. By starting with a term structure of interest rates and developing tracking tools, DeFi borrowing and lending will have the maturity to realize their potential and fundamentally change the world of finance.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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