Decentralized finance (DeFi) has rapidly evolved, with lending protocols emerging as a dominant segment. Currently, these protocols boast a total value locked (TVL) of $33 billion, representing about 33% of the entire cryptocurrency market.
The bulk of this TVL is concentrated in overcollateralized lending protocols, where users deposit cryptocurrency as collateral to borrow a lesser amount. Prominent platforms like AAVE and Compound have been pioneers in this space. For example, on Aave, the maximum loan-to-value ratio for USDC is 75%, allowing users to borrow up to $75 for every $100 of USDC deposited.
Despite the success of overcollateralized loans, many industry observers predict that the future of DeFi lending will align more closely with trends in centralized finance, where uncollateralized or partially collateralized lending is prevalent. According to Allied Market Research, the global market for unsecured business loans is poised to reach $12.5 trillion by 2031, expanding at an annual growth rate of 11%.
One direction for uncollateralized loans in DeFi is so-called flash loans. Flash loans let a user borrow money without any collateral and pay it back in the same transaction. The requirement is that borrowing and repaying the money must happen within the same blockchain block. If the user can't repay the loan in the same block, a smart contract will cancel the transaction and return the money to the lender. However, due to this design, the utility of such loans is limited.
Unlike flash loans, where the return of the funds is programmed into the tokens, uncollateralized loans use a different scheme to provide security for the lenders. Generally, such services connect lenders, brokers, and borrowers on multi-sided platforms that incentivize each party to act for the common good by various on-chain and off-chain mechanisms. For example, 'backers' in Goldfinch are responsible for assessing the borrowers and at the same time need to invest their own 'first-loss' capital in the proposed pool.
In the DeFi space, several protocols already offer uncollateralized loan products. Among them are Goldfinch, Maple, Clearpool, and TrueFi. Goldfinch, for example, reports approximately $70.7 million in active loans across 25 deals, with annual percentage yields ranging from 10% to 20%. Borrowers span a variety of sectors and regions, including banks in Latin America and Southeast Asia, as well as debt platforms worldwide.
However, the lack of collateral in these loans means a higher risk of borrower defaults. Goldfinch recorded a 5% default rate in its portfolio. Recently, it faced defaults from a lender, East, that failed to pay back $5.9 million out of a $10.2 million loan. Additionally, in December 2022, Maple saw Orthogonal Trading default on eight loans totaling $36 million. TrueFi also encountered repayment failures from Invictus Capital and Blockwater Technologies, which totaled $4.4 million.
As in traditional finance, the main challenges in this sector are accurate assessment of borrower creditworthiness and effective risk management. Many of the emerging uncollateralized lending firms are relatively new and may encounter difficulties in navigating the complexities of credit assessment, even if they are rightly incentivized.
Moreover, the underwriting process in crypto lending is still developing and remains less standardized than in traditional finance, adding layers of risk.
Uncollateralized lending in DeFi brings numerous challenges and risks but also presents opportunities for greater transparency, lower transaction fees, and improved interest rates by eliminating traditional financial intermediaries. As the sector matures, it will inevitably undergo growing pains, yet the potential rewards for successfully navigating these challenges could be substantial.
