Under the sweeping "real rate of return" narrative, undercollateralized lending income has become more and more researched and sought after in DeFi. Recognizing the excellent existing coverage of this topic in the crypto media, we at Treehouse Research also wanted to share our thoughts on a few different perspectives.
In this article, we will first understand what credit is and why it is important to the economy and business. Then, research popular DeFi credit protocols, and their pros and cons compared to TradFi/CeFi lending. We will summarize a few points that we believe are critical to the next phase of growth in the DeFi credit market.
Credit: The Modern Way of Borrowing
Borrowing and borrowing is one of the oldest socioeconomic behaviors in human society, dating back to ancient Mesopotamia. Ancient loans started as pawnbrokers, which were simply loans secured by items believed to be of value. Early forms of credit arose because resource owners lent production materials to labor workers with the expectation of repaying the goods. If the borrower did not repay, his family risked being held as slaves.
Today, credit is important to businesses and entire economies because it allows economic units to raise working capital without diluting equity. This leverage leads to increased investment, capital spending, and consumption, which leads to rapid economic growth.
In TradFi, credit can generally be divided into secured loans and unsecured credit loans. A mortgage is a type of secured credit because the loan is secured by property. A credit card is a type of unsecured credit, or it can be thought of as collateral against the creditworthiness of the borrower. Credit creation means balance sheet expansion. For example, in a typical mortgage, the buyer makes a down payment of 10-50% of the market value of the property, with the bank financing the rest. The difference between the property value and the down payment is credit created by the commercial bank. In the grander scheme, the Fed buys U.S. Treasuries, an act of borrowing money from the U.S. federal government — the credit the Fed (central bank) creates to sovereign nations (governments).
In contrast, in DeFi, most existing lending protocols are based on over-collateralization, similar to pawn shop lending, and do not involve the creation of credit. If Elon Musk had to put down $1 billion worth of Tesla stock to borrow $500 million to buy a house, it would be the equivalent of an over-collateralized mortgage in DeFi - not very attractive to someone who already has $1 billion because he can easily find a bank willing to lend him US$10B.
Credit as a Business Financing Channel
Traditional enterprises have two financing methods: debt financing and equity financing. Equity funding involves diluting ownership, which founders avoid, especially in the early stages, to avoid losing equity upside. Equity financing does not create credit because the business sells "a piece of itself" for cash.
To raise working capital while maintaining majority control over their operations and business decisions, businesses opt for debt financing. Debt financing creates credit because the lender provides cash or other working capital in exchange for future repayments of principal plus interest, rather than a controlling interest. Lenders also avoid taking equity risk because they have a claim on the borrower's assets while equity holders do not. This form of financing or loan is usually offered after a business or company has managed to clear all the claims made by financial institutions.
What prevents credit creation in DeFi?
As mentioned earlier, DeFi lending still largely follows the age-old pawnshop model — the borrower puts down something of value as collateral, and then withdraws cash that is less than or equal to the value of the collateral. This is ultimately because DeFi lending protocols are permissionless, which is procedurally efficient and does not bias against any borrower. However, this hinders the pre-loan credit checks and know-your-customer (KYC) procedures that typically precede credit origination in the TradFi world. Since mainstream DeFi lending protocols cannot know the real identity of borrowers and assess their credit risk, they can only ensure that lenders remain intact through over-collateralization.
Overcollateralized lending provides the financial sector with many trading and hedging strategies. Since they do not create credit, their use cases in non-financial businesses are limited since only asset owners can borrow and the poor cannot leverage. Even for asset owners, there are more effective ways to leverage than participating in DeFi lending. For example, someone with $10 million worth of crypto assets might be able to borrow $20 million from a CeFi institution that does KYC and credit checks. Essentially, the core DeFi principle of being permissionless prevents the growth of the DeFi lending market.
Emerging DeFi credit protocol
Currently, as of December 5, 2022, the cumulative TVL of DeFi lending agreements is US$13.96B, and the monthly lending volume in the past year has ranged from US$9.37B to US$32.46B. While this number has remained steady even during the recent market contraction, the size of this currency market still pales in comparison to the TradFi market.
The size of the credit market in TradFi is about $91T, which is larger than the TradFi stock market and the DeFi money market. This is largely due to capital inefficiencies and a lack of means to assess and price DeFi credit risk.
The introduction of credit protocols into the DeFi space has sparked intense interest from institutional borrowers and lenders, especially at a time when Liquidity is being drained from the global financial system by central banks.
The size of the credit market in TradFi is about $91T, which is larger than the TradFi stock market and the DeFi money market. This is largely due to capital inefficiencies and a lack of means to assess and price DeFi credit risk.
The introduction of credit protocols into the DeFi space has sparked intense interest from institutional borrowers and lenders, especially at a time when Liquidity is being drained from the global financial system by central banks.
Credit agreements originate a total of $4.2B in loans in 2022, and there is an increase in institutional borrowers.
In addition, the default of large CeFi lenders such as Celsius has led to an overall credit contraction in the crypto finance space, as the risk appetite of CeFi lenders has decreased, leaving crypto institutions with fewer options for obtaining credit. As a result, emerging DeFi credit protocols can seize the market share vacuum left. For example, Maple Finance noted in its Q2 report that lender demand remained strong throughout the year, with 23% of lenders increasing their loan positions, increasing demand for borrower capital. Clearpool also reported that the total Liquidity it provided peaked at $145 million in September 2022, a 30% month-on-month increase, while DeFi’s total Liquidity declined by 26.7%. Excessive growth in DeFi credit origination often corresponds to a CeFi credit crisis.
Business Model of DeFi Credit Protocol
Most DeFi credit protocols currently do not issue loans directly, but act as credit infrastructure providers by connecting borrowers and lenders. The main source of income for these credit agreements is similar to its overcollateralization agreements, namely a portion of the interest income from outstanding loans. Once entrants start making loans, these credit agreements typically either take a percentage of the interest income those loans generate, or they charge a small fee when the loans are made. Clearpool, for example, uses a pooling and lending model that charges 5% of all interest payments collected as a protocol fee. The protocol that runs the loan business setup model, similar to Maple, charges a 1% setup fee when the loan is originated by any institution with a pool of funds on the platform. 67% of this fee is sent to Maple DAO as protocol revenue.
Over the past year, the Credit Agreement has managed to generate a total of $10.9 million in revenue. This revenue growth has been relatively steady due to the ongoing Liquidity needs of institutions using these protocols.
Despite the broader crypto Liquidity contraction, the three largest credit protocols by monthly borrowing volume: Maple Finance, TrueFi , and Goldfinch have generated relatively stable monthly revenues over the past year.
The two broad categories of institutions to which these credit protocols are funded are crypto-native institutions and corporations in emerging markets. The crypto-native institutions currently actively lending on these protocols are primarily hedge funds and trading firms. These companies, while performing similarly (if not) to their TradFi peers, and having healthy balance sheets (although we did see surprises in the FTX drama), were unable to obtain loans through traditional institutions such as banks.
Emerging markets are another group of borrowers financed by these credit agreements. Demand for private debt exposure continues to grow throughout 2022, with emerging debt markets following this trend as the startup and technology ecosystem in the space continues to grow.
Emerging debt markets offer investors favorable risk-reward portfolios, creating demand for exposure to such debt instruments. However, investors may find it difficult to access debt markets in emerging economies. So, to solve this problem, certain credit protocols provide access and benefits by connecting potential lenders and borrowers. Goldfinch, an agreement currently serving emerging market borrowers, states that in order to minimize the risk and uncertainty of providing credit to industries that are still in the growth phase, they only provide loans to established credit funds and fintech organizations with historically stable financial performance. Also, ensuring that borrowers meet satisfactory standards is against Goldfinch and Credix, as the aggregate default rate has been 0% since inception.
Credit Agreement Infrastructure
The current process of extending credit to these agreements is relatively similar, with some nuances in the protocol mechanics and loan management.
protocol level
A credit agreement typically acts as an infrastructure layer, providing the necessary risk assessment and credit scoring expertise required prior to loan origination, as well as making protocol-level decisions such as interest rate regimes. While such credit risk assessment decisions may centralize some aspects of these protocols compared to other DeFi money markets, they are critical to ensuring that the quality of borrowers on the platform meets certain standards to minimize credit risk. important. Protocols either have teams with years of credit experience, or use a centralized credit rating provider like Credora to assess the financial health of each potential borrower.
Protocols are also usually responsible for setting interest rates for their loan pools, which can be dynamic or have a fixed default level. Examples of fixed-rate protocols include Maple Finance and TrueFi, as the terms of loans for their lending pools are typically determined off-chain by both the borrower and the party running the pool. Dynamic rates typically use an algorithm that takes pool utilization into account to determine the appropriate rate. This approach is used in protocols like dAMM .
Borrower
How to borrow?
The process for borrowers in most credit agreements is relatively standardized , and they must complete KYC and anti-money laundering (AML) procedures stipulated in the agreement, and have their financial situation analyzed before opening a loan pool. After completing the necessary procedures, the borrower can open a loan pool, usually similar to a revolving credit line, in which funds can be borrowed up to a certain amount and can be borrowed at any time. Because there are enough funds available. These processes apply to most protocols that allow institutions to build their own pools and borrow directly from them, such as dAMM and Clearpool.
However, for agreements using a business model that allows an institution to set up a credit facility, the borrower typically must go through an additional third party in the set up process. This additional party acts as a pool manager, interacting directly with borrowers and negotiating credit terms with them. These mining pool managers usually have to pass KYC checks by agreement when the pool is set up by them. Becoming a pool manager is similar to running a credit business, borrowers have to interact with them to get a loan. Borrowers can also start borrowing from these pools once these loans are approved by administrators. Protocols that follow this structure include Maple Finance and TrueFi's Capital Markets, where each pool is run by an institution that pools funds and approves each borrower itself.
interest payment
With most agreements, interest is automatically compounded each period, giving borrowers the flexibility to choose to repay the loan as they see fit. However, there are some agreements, such as TrueFi, that only require interest repayments at the end of the loan term, which leaves the borrower under no obligation to pay interest until the repayment date arrives.
lender
How to lend?
Currently, most credit protocols run permissionless pools, meaning that lenders can choose to deposit funds in any pool they choose. As long as users have a compatible Web3 wallet and asset pool to deposit into, they can provide funds to the lender of their choice to start earning interest. However, for some protocols and licensed pools, lenders are required to complete a KYC/AML process before depositing funds into these pools. Currently, the three protocols that require lenders to complete KYC before being able to deposit funds are Goldfinch, Centrifuge, and Credix.
vanilla lending pool
Most current protocols employ a model in which lenders simply select the institution they wish to lend funds to and deposit funds into the corresponding pool. This is similar to funding on AAVE , except that the borrower is an institution that has gone through the KYC process and joined through a credit agreement.
Tiered Loan Pools
There are several protocols that split their loan pools into different tranches, enabling lenders to choose the amount of risk they are willing to take in order to earn interest. Centrifuge is an example of a protocol that offers segmented loans in the form of different tokens representing junior or senior loans. Lenders who choose to lend their funds to the junior tranche will typically earn higher yields because they will provide first loss capital in the event of any default. Lenders in the senior tranche, on the other hand, get lower yields, but are saved from default because of the Liquidity in the junior tranche.
interest payment
For most protocols, once a lender deposits funds, he cannot withdraw them until the loan term ends or there are sufficient funds in the pool. This may mean that the funds provided are Liquidity over the life of the loan. If a lender deposits funds into a pool at which point their funds are fully utilized, the lender will not be able to withdraw funds until the next interest payment or until the loan is fully repaid.
DeFi as an equalizer for credit access?
DeFi credit protocols appear to be just on-chain iterations of traditional banks or lenders due to their centralized nature compared to their over-collateralized counterparts. However, DeFi credit protocols have advantages throughout the loan process and lifecycle that TradFi cannot replicate.
Evolution of the credit process
In TradFi, the amount of credit a person can receive is determined by a framework commonly referred to as the "5Cs of Credit". This framework plays an important role in determining how much credit to extend to a party wishing to obtain credit. This is also referred to as the creditworthiness of the party requesting credit.
These 5Cs are often assessed together to get an accurate picture of a potential borrower’s current financial situation. For example, if an SME wishes to obtain a loan from a bank to finance the purchase of machinery, they will be assessed by the 5Cs. However, the process of getting a loan is not as simple as approving a wallet transaction in MetaMask like getting a loan on AAVE , instead it requires the participation of multiple parties and individuals to complete each step of the process.
Therefore, getting a TradFi loan is not only expensive but also time-consuming. Data shows that only about 7% of TradFi loans are processed in an average week, and the involvement of multiple parties can lead to a surge in loan costs. In addition, applying for a new line of credit at a financial institution with which the borrower has an existing relationship may still need to go through the full 5C review cycle again. The operating costs of all these processes will likely be borne by the borrower in the final loan pricing, as TradFi loans (legal ones at least) are highly monopolized by established financial institutions. Therefore, the cost of the aggregate is likely to be borne by the borrower in the total loan pricing.
The inefficiencies of Tradfi’s archaic process are simplified by the current DeFi credit model, which provides operational flexibility for borrowers to borrow and repay 24/7 after initial borrower applications are approved.
Clearpool's loan origination process is an example. With Clearpool, borrowers go through just two intermediaries — the protocol itself and Credora. Additionally, the number of steps and processes required to approve and initiate a loan request is significantly reduced compared to TradFi institutions. The middleman is eliminated so borrowers can earn competitive interest rates from DeFi mortgage protocols. The tedious technical details involved in TradFi borrowing, such as waiting for loan withdrawals to be credited to the borrower's account, or transferring borrowed Liquidity to the destination account, can be effectively replaced by blockchain technology.
Greater credit availability for underserved borrowers
DeFi credit protocols, while not perfect, make it easier to get loans to borrowers who were previously considered “underserved” and/or priced out by legitimate TradFi/CeFi lenders (loan sharks, of course, are out of the context of this article). For example, after the 3AC fiasco, aspiring cryptocurrency market makers may find it difficult to increase leverage by borrowing from CeFi lenders, and they certainly have no hope of expanding their balance sheets through repo transactions with TradFi investment banks. Similar hurdles exist for many crypto financial institutions, and DeFi credit offers an inexpensive and non-dilutive alternative to bringing in new venture capitalist (VC) capital. In the non-financial sector, DeFi credit also fills a gap for companies in emerging markets (Latin America, Africa, and emerging Asia).
Businesses in emerging markets face a significant financing gap, as many are underserved and lack approximately $500 million in annual investment. A number of credit protocols have attempted to fill this gap, one of which is Goldfinch, which specifically connects lender capital with borrowers in developing countries, where access to TradFi credit is expensive and inconvenient. While 5C credit due diligence is still performed on borrowers on Goldfinch, credit risk assessment is at least done through a decentralized consensus (among stakeholders) rather than a corporate monopoly.
While DeFi credit protocols currently only serve a niche market, there are several avenues for greater adoption. One understandable trajectory is the mutual recognition of credit scores/ratings between users and entities in DeFi and TradFi, which would allow borrowers with credit histories on the one hand to access credit on the other. This would benefit not only institutional borrowers but also retail borrowers and potentially make on-chain credit cards a reality. However, mutual recognition of credit scores may require borrowers to reveal their true identities for KYC and compliance purposes. This could undermine maximizing decentralization.
Transparency, Anti-Fraud and Risk Management
The development of DeFi credit protocols offers a promising cure for several problems in the TradFi and CeFi credit markets.
Most importantly, DeFi lending is on-chain and auditable, balancing access to information between lenders. In contrast to TradFi, in some cases lenders with private credit exposure to borrowers learned of impending defaults earlier than lenders with only public debt exposure. Private credit lenders have an unfair advantage in faster access to information and may reduce their risk exposure at the expense of public credit lenders. Despite insider trading laws, such cases are difficult to prove in court, so lenders without an information advantage stand to lose. If an institution does all its lending through DeFi, transparency will prevent the aforementioned information gap and bring fair and true equality to all lenders.
Protocols like Clearpool provide real-time credit scoring by using Credora, where information about borrowers and their respective loan pools is readily available. They also provide users with information on loan sizes and repayment history, as well as transaction hashes, should lenders wish to track where each borrower is going. Although credit terms such as collateral size are not visible to users, they still have a higher level of access to information than lending to CeFi institutions.
Admittedly, at this stage, many whitelists DeFi borrowers are not solely borrowing on-chain, leaving a potential informational advantage for CeFi lenders. However, as we observed during the CeFi credit crunch from May 2022 to July 2022, publicly scrutinized on-chain borrows are often repaid first (in part to free up asset collateral, but also due to regulatory pressure) .
Consensus mechanisms in DeFi credit due diligence can also help reduce fraud. The traditional loan approval process of financial institutions often relies on a small number of decision makers, which presents centralization and key personnel risks in fraud prevention. _Netflix fans may remember the heroine Anna Delvey or Anna Sorokin from the true story adaptation of the TV series "Inventing Anna", who faked her identity and managed to trick banks into extending credit lines on false impressions and forged documents . It’s hard to imagine her accomplishing this in the context of DeFi lending, where KYC is conducted by a group of protocol stakeholders (e.g. token stakeholders).
existing credit agreement
In the table below, we compare current and well-known credit protocols in DeFi using various qualitative and quantitative metrics.
Current Limitations of DeFi Credit Protocols
Despite their achievements, popular DeFi credit protocols still face limitations that, to varying degrees, hinder further adoption.
lack of term structure
This shortcoming is by no means limited to DeFi credit protocols. Most DeFi money markets operate on a zero-duration basis, as investors remain largely stuck on Liquidity investments due to smart contract risk. Depending on the protocol, a DeFi credit pool can be structured as a revolving credit facility that borrowers can draw and repay on a flexible schedule, or as a short-term fixed-term credit line with a term of less than six months. The only exception is Goldfinch, which allows companies to access three-year borrowing arrangements.
Currently, the lack of duration is less of a concern as the majority of DeFi credit borrowers are financial institutions such as trading companies, as these borrowers are usually content with short-term funding. This allows them to enjoy the flexibility to shrink their balance sheets when market opportunities are not suitable for heavy borrowing. However, for credit investors, some are increasingly comfortable taking smart contract risk and looking for longer-term fixed-rate income. The needs of these investors may be better met with differentiated, long-term offerings.
Concentration industry risk
As mentioned above, most DeFi credit borrowers operate in the same sector, which exposes lenders to higher correlations between their loan portfolios, also known as higher joint default probabilities. Goldfinch’s model of bringing in non-financial borrowers helps bridge this gap with diversified on-chain lending.
Lack of consensus credit rating framework
With the advent of on-chain credit rating providers such as Credora, the current lack of a standardized DeFi credit rating framework may soon be resolved. Investors currently have no easy way to assess the creditworthiness of borrowers: they either have to establish bilateral relationships and collect financial statements, or rely on rating providers.
Legal and Compliance Implications
There are many unclear legal implications when it comes to DeFi credit. First, a DeFi credit origination does not necessarily provide a prospectus like a TradFi credit bond issuance. Missing prospectuses and legal documents can lead to issues including, but not limited to, illegal solicitation and unclear debt priorities. How do lenders determine if their loan is parity with the borrower's other off-chain unsecured liabilities? On default, do off-chain creditors have the right to accelerate DeFi obligations even if DeFi credit pools pay on time? Are on-chain proofs of loans to borrowers legally binding in court? All of these delicate procedural necessities must be resolved before DeFi credit markets gain greater adoption.
Insufficient capital Liquidity
Although most DeFi credit pools currently have no clear Vesting period for funds, lenders must not consider their investment principal as Liquidity. The amount that can be withdrawn is determined by the utilization rate, which means that if most of the available pool funds are borrowed, the lender needs to wait for repayment or new funds to come in before withdrawing funds.
While some protocols provide “Liquidity exits” by allowing lenders to sell their tokenized loan tokens on the open market, lenders will still be in trouble if they withdraw heavily from pools, for obvious reasons. This might be better addressed by distinguishing between term loans and revolving credit facilities, so that lenders can determine how long their funds have been locked up and can proceed to plan accordingly.
Another way to increase Liquidity for DeFi credit borrowing is to introduce market makers into tokenized loans — similar to how TradFi market makers use principal balance sheets to provide secondary Liquidity. The obvious obstacle to this route is the lack of credit instruments (credit default swaps, shorting tokenized loans, etc.), which reduces the ability of market makers to hedge risk, thereby reducing market depth.
future development
In this section, we outline several directions that we foresee the DeFi credit space eventually taking to someday make universal DeFi credit a reality.
retail credit
In TradFi, credit is heavily used by the retail industry to finance big-ticket purchases like cars or mortgages, and more general use cases like paying for college education. The availability of retail credit in DeFi will be a major value proposition.
The Gearbox Protocol is an example of an attempt to address the retail DeFi credit market. It provides retail credit through the use of credit accounts, which are segregated smart contracts with set parameters allowing access only to whitelists tokens and protocols to implement yield or trading strategies using credit loans. This model allows for the creation of credit without the need for KYC, as borrowed funds are not directly held by users, which eliminates the Rug Pull of them defaulting and running away with borrowed funds.
For now, retail DeFi credit is still limited to financial use cases, while consumer use cases remain very limited due to the difficulty of determining on-chain identities. In our opinion, one possible solution to the “default incentive” problem is the use of soul-bound tokens (SBT). These non-fungible and non-transferable tokens will ensure that if a user defaults, he will not be able to obtain future loans as his credit history will be linked to his on-chain identity. As the technology stack continues to evolve, we foresee SBTs playing a central role in ensuring retail consumer credit compliance becomes a reality.
Zero Knowledge KYC (zkKYC)
Current credit agreements require all borrowers and certain lenders to undergo KYC/AML procedures, which are currently still centralized and have no industry-wide standards.
zkKYC will allow users to prove their identity without fully disclosing all personal data, while still complying with all necessary KYC obligations. This also helps to provide standardized KYC procedures across different credit protocols, potentially increasing the composability of decentralized identities across different protocols while protecting user privacy.
final thoughts
Despite the many hurdles ahead, the DeFi credit market has demonstrated its momentum and ability to foster innovation. As one of the most heavily traded risk premia in TradFi , credit risk could become the next heavyweight in the "real return" narrative.
Perhaps the most interesting observation about DeFi credit is that the growth of this market is directly opposed to the decentralization of "DeFi". Both lenders and borrowers voluntarily undergo KYC and whitelists to participate in these protocols, placing anonymity at a lower priority. This permissioned on-chain marketplace is likely to be a lasting trend that will lead to an increased institutionalization of on-chain financing and investment activity as regulators dig deeper into transactions and returns that were previously out of their reach. The long-term impact of this development is difficult to measure, as DeFi's initial concerns about erosion of privacy and distributed governance may be addressed by future innovations that allow permissionless and algorithmic credit assessment.
All things aside, we at Treehouse are optimistic and excited to be a part of the growth of the DeFi credit market as our engineers work hard to integrate credit risk management tools . We believe that the next star project in the DeFi credit space will likely involve tools and marketplaces that allow credit to be traded more efficiently and across a more diverse set of borrower entities, or with a variety of maturities The index package for the structure.
