The lending platform is one of DeFi’s main models. Its future development direction and innovation opportunities have been the focus of DeFi practitioners, with attempts in directions such as introducing “credit loans” and new collateral. This paper analyzes from the perspective of the characteristics of DeFi lending platforms and the demand of market liquidity, and presents how lending platforms would develop in the short-term and the long-term, as well as providing specific designing suggestions for the mortgage model of some assets, which can be viewed as references for platform developers and operators.
1. What is the DeFi Lending Platform?
Interest Rate Protocol and Money Market
A few months ago, Jake Chervinsky, general legal counsel for Compound, published the article DeFi Protocols Don’t Do “Lending”, and in the article, he discusses the difference between “interest rate protocol” or “money markets” and the traditional concept of “borrowing” in the financial sector. The article clarifies some of the misconceptions about DeFi lending protocol and, to a certain extent, explains its current status: most existing DeFi lending protocols follow the interest rate protocol or money market model presented in the article, rather than the traditional credit-lending model.
However, the article did not fully answer a series of questions: why participants entered the “interest-rate market”; what value the market brought to them; why the pledge rate was generally set at 50–75%, a similar ratio to mortgage lending, but not higher or lower.
The Pawn Model
In my opinion, all types of existing DeFi lending platforms are closer to a kind of pawn model at the level of protocol. The pawn model has the features of mortgage lending and money market, so over-emphasizing on one aspect can lead to misunderstanding and deviation of development direction.
On one hand, as the article discussed, if we understand this business model as borrowing, we would inevitably develop towards a broader lending model, such as credit loans (unsecured), which is exactly what some DeFi platforms claim to do. From this point of view, I agree with Chervinsky that this is an area that DeFi protocol should not involve in. At least for now, smart contracts know nothing at all about men’s credit and repayment ability in the real world, and recording credit information on block-chain is far less effective than the centralized model of combing big data with risk control.
On the other hand, simply emphasizing the characteristic that borrowers do not have to repay their loans does not fully portray the real motivation behind borrowing, and thus does not explain the value of the market. For example, if money markets reflect only the supply-demand and interest-rate differences between currencies, why not just imitate the foreign exchange markets? Stable currency exchange market applies this model. The essence of this model is Exchange, but not the current mortgage-lending model. Thus, we cannot deny that the essence of DeFi borrowers is to collateralize their borrowing with excess mortgage assets to gain the value of borrowed assets, whether it acquires liquidity by buying value-added assets or takes profits by selling short, they ultimately have to repay to cash in real gains. As Chervinsky says, “Borrowers are free to leave and never have to repay, without any additional risks to lenders.” This is just a possible outcome, not a motivation.
The characteristics above are very similar to pawn. On one hand, pawn is a standard pledge model, and pawnshops generally do not have the ability of banks to create money, so the source of its funds is simply self-owned funds or third-party funds (Mortgage loans appear to be similar to DeFi lending protocols and pawn models, but involve credit derivatives in their essence, so it is a completely different financial model, which will not be discussed here). The source for fund pools of DeFi platforms is consistent with this. The pawnbroker, on the other hand, is essentially a model of exchanging the pledge of low-liquid assets for liquidity. In the end, if the pawnbroker fails to redeem the pawn in time, the assets will be cleared. The difference between DeFi lending and pawn-holders is only in terms of the conditions for clearing, counter-parties and processes.
This latter point is crucial, although, on the surface, the pawn shop and DeFi lending platform have completely different roles in the process of financing and clearing, but, in nature, they are the same in the direction of assets and funds transfer, which can be compared to the difference between self-owned e-commerce and platform e-commerce. Therefore, the existing DeFi lending system/interest rate protocol/money market is essentially a “third-party pawn platform business”, which provides the protocol infrastructure, connects the supply and demand parties, and charges the interest rate spreads and the service fee.
2. Liquidity provision is the core value of the DeFi protocol
All financial systems are essentially liquidity-providing mechanisms, such as exchanges, lending, insurance and derivatives. Pawnshop is one of the standard liquidity-providing mechanisms. In many articles and courses, the author has expounded that DeFi is a better liquidity-providing model, and thus a better financial service system due to its liquidity carries features of transparency, borderless nature and contract certainty. Therefore, we should analyze the role of DeFi platform from the perspective of liquidity provision, and then decide where its future development is heading.
Who are the real demanders for mortgage loans/pawns
In the author’s pinion, as a pawning model, DeFi lending can satisfy their needs only by giving the pledgee the ability to exchange low-liquidity assets for high-liquidity assets, which is the fundamental reason for their entry into this market.
Looking from this perspective, we can see that mainstream lending platforms, such as Compound, generally support only a few basic currencies to “mortgage” with each other, (even recently added some currencies but it is still a small deposits), and these currencies are actually high-liquidity assets that can be cashed in at any time, and even buy other assets as basic currencies (e.g., ETH) in exchanges. Therefore, storing these basic currencies as collateral to borrow other basic currencies actually reduces the total liquidity (since the ratio is usually 50–75%, significantly less than the value of the original assets). For the people who store these assets to borrow, they are not real liquidity buyers, and many of them are arbitrageurs revolving collateral based on the logic of rising currency prices. For the whole market, the overall liquidity has actually shrunk (because more liquidity has been locked in, not into the market), that leverage has risen, and the risk of assets being liquidated has increased, which is not necessarily a healthy model.
Therefore, who are the real demanders of liquidity in the DeFi market? There are generally two kinds of people: one is those who own non-mainstream currencies, such as investing in projects that hold large amounts of tokens (commonly referred to as “small currency”), but at a price that is not properly cashed in. Another is those of the DEX market makers, whose funds provided to DEX can obtain market-making income, but they get the liquidity pool voucher (LP) itself is a kind of illiquid assets. If they go to the secondary market to sell, they lose the underlying assets, fee income and all other rights. So, their liquidity was frozen by market making.
For both groups, mortgage lending is clearly the main, if not the only, model that can help them access liquidity. But for platforms, the first group has asset prices that are volatile and their use as collateral is clearly inappropriate, so the platforms are cautious about opening up lending in small currencies, at least by setting their collateral rates very low. For the LP of the DEX, it is obvious that the asset value of mainstream currency transactions is guaranteed, even if for the “XXX-USDT”, half of which is small currency, and another half is mainstream currency transactions, the volatility of LP is less than single currency volatility, and at least 50% of the value is guaranteed. Meanwhile, considering that the LP has market-making income, LP mortgage lending is allowed to be used, which is similar to the model of stock pledge: assets, rights, earnings still belong to themselves, but they can get new liquidity, or be further invested in other assets. In the future, it can be redeemed only with pay interest, which is the real model of raising liquidity.
Therefore, we can draw the conclusion that, DEX market-makers are the real players in the DeFi market at this stage, who have the right assets for mortgage lending (pawning) and the need for liquidity. Lending platforms should design mortgage-lending models for such assets and encourage this group to borrow.
The Current Status of LP Mortgage Lending and Improvement Measures
When we look at the current mortgage market, we see an obvious phenomenon: LP mortgage lending is hardly going on: Compound does not open up mortgage lending at all, and AAVE has opened up some UNISWAP LP’s lending pool, but which was left there without almost anybody to care for it. The status quo seems to be contradictory to the conclusion made above. To do this, we need to analyze from the platform and the mortgagor’s point of view respectively:
First, from the platform perspective, LP is a low-liquidity asset, in other words, they are less likely to be loaned. After all, the people who borrow the assets intend to get liquidity to invest in other assets. As a result, the storage of LP becomes a mere “liquidity taker” without providing liquidity to the platform, which leads to differences between TVL and the total liquidity. If the difference is large, it can be consider there is a risk of a liquidity imbalance across the platform, which means there is a relative shortage of money to borrow. Of course, this can be improved by adjusting algorithms and parameters, such as reducing the pledge rate for LP assets, or placing them in a separate pool like AAVE, which does not take up the borrowing capacity of other pools and can also raise their lending rates. As we discussed in previous paragraphs, LP mortgage lending is “rigid demand” for DEX market makers, and clearly these measures do not affect their borrowing needs.
Second, from the point of view of LP holders, there are two problems that may affect their storage willingness (AAVE, after all, has launched LP lending without a lot of storage). The first is that LP has fee income. From the contract level, during the mortgage, LP is not in the hands of the platform, and there is double about whether contract will get LP corresponding fee assets. In addition, after platforms such as Uniswap have launched liquidity mining, some LP can be mortgaged to these platforms to mine, if the lending platform does not have the ability to help users with mortgage, LP holders would lose potential mining profits. Second, if LP assets can be loaned out, the problem above is more serious: it is good for borrowers to have fee income and mining income before the borrower returns, but the original holder lost revenue. In addition, borrowing LP can be a bit of a hassle for borrowers, because lending interest is denominated in LP, so borrowers have to operate by themselves to increase liquidity, so they can return all their assets, which is also a cumbersome process. To solve these problems, it can consider the labeling LP as a “non-loanable” asset, so that the holder has no risk of transaction fees or mining losses. At the same time, the platform should be able to transfer the assets to the corresponding mining platform to obtain mining proceeds for users (also depends on the premise that LP assets cannot be borrowed). As a result, the lending platform has the same ability with some of the platform dedicated to helping users with LP mining platform, while at the same time it can allow users to borrow to increase liquidity, which will reflect a clear competitive advantage.
3. Development Directions and Opportunities of DeFi Lending Platforms
Overall, DeFi Lending Platform is a platform that provides users with liquidity through mortgage lending/pawn models. It finds users with liquidity needs, and designs corresponding mortgage lending models for their illiquid assets, which should be the main direction of the platform.
The second part of this paper takes the LP assets of DEX market-maker as an example, analyzes the liquidity demand of the holders, and gives the ideas and key points of designing mortgage and loan products for LP assets. In this basic model, DeFi lending platforms should develop in the direction of looking for other collateralised assets to serve a wider user base.
At present, we see that platforms, such as MakerDAO, even are not a model of borrowing, but are also greatly expanding the type of mortgage assets. Especially with the introduction of “real world assets” rather than native digital assets as collateral, it is a very important step. For DeFi lending platforms, the people who own such assets, is apparently the demander of liquidity, to whom the platforms should provide with mortgage lending services. At the same time, their demand for asset mortgages is closer to LP assets rather than high-liquidity assets, such as a person who wants to mortgage a house for liquidity, apparently he or she does not want his or her house to be “loaned” by others on the platform. Therefore, LP’s design can basically extend to digital voucher mortgage lending models of real-world assets.
As we all know, “physical asset chain” is a commonplace problem. There is no perfect “Trustless” solution, so it must be based on the credibility of asset managers. For example, the house chain must have the real estate management organization to cooperate with, so it can guarantee that the house ownership can transfer to the liquidator hand when the asset clears. Gold, dollar and other assets must also be digitized by the financial institutions that manage them, so that they can enter the DeFi world. In this process, financial institutions, which are the same as the concept of “digital banking”, should have inherent advantages. The term “digital bank” refers to a financial institution that, on one hand, has a commercial banking license, and can engage in asset management, mortgage and currency issuance, while on the other hand, it can convert a legal tender into a stable currency on a block chain, and can digitize vouchers such as gold and property.
This kind of financial institution is the bridge between the real world and the digital world. The author has always called it “the bridge of the parallel world”. The platforms, such as DeFi lending, can cooperate with this kind of financial institution to further improve the efficiency of providing liquidity, which is the major opportunity for the development of DeFi lending platforms, and is also the only way for future continuous improvement of DeFi’s overall scale.
Unizon is a development team, dedicated to blockchain and open financial technology, and specializing in DeFi protocol development, technical advisory services, and model design for Tokenomics.