From Pawnshops to Credit Institutions: How Far Are We from Crypto Credit Loans?

This article is sourced from Bankless, authored by Roman Buzko, founder of Lazzy Ventures, and translated by Wang Dashu and Hu Tao.

From a historical perspective, the business model of DeFi is similar to that of pawnshops, which have a history of hundreds of years. Borrowers submit valuable collateral, and lenders issue loans based on the value of that collateral. However, as times have progressed, pawnshops have gradually been replaced by credit lending.

So, will DeFi also evolve from an over-collateralized business model to credit lending in the future? Recently, Roman Buzko, founder of Lazzy Ventures, wrote an article on this topic in Bankless, using it as a starting point to explore how DeFi can establish credit lending models and other related issues. Chain Catcher has compiled this without altering the original meaning.

Currently, the main form of lending in DeFi is over-collateralized loans. To obtain $100 worth of DAI, a borrower needs to deposit $150 worth of ETH as collateral. Of course, there are products attempting to offer under-collateralized loans, but no successful examples have emerged yet. This article will focus on various existing and yet-to-launch crypto lending protocols, as well as the potential for on-chain credit lending in the future.

Today's leading DeFi lending protocols are reminiscent of past pawnshops. As more assets enter the blockchain, the range of collateral will eventually cover NFTs and tokenized real-world assets.

However, the main obstacles currently are limited liquidity and poor price discovery. Under-collateralized DeFi loans will first be available for off-chain legal entities and have already gained some momentum. For individuals to obtain under-collateralized crypto loans, two things are necessary: digital identity and digital reputation.

The primary reason all loans in DeFi require over-collateralization is that both parties in the lending process possess anonymous identities in a true crypto sense, with lenders unaware of the borrower's identity and reputation, and vice versa.

In the absence of any credit score for the borrower, lenders can only offer credit at amounts below the value of the collateral. Typically, the LTV (LTV = loan/collateral value * 100%) must be below 100%.

According to the aforementioned formula, with a $100 DAI loan and $150 ETH as collateral, the LTV equals 67%. Currently, the average LTV in major DeFi lending protocols ranges from 50% to 80%, depending on the quality of the collateral asset. This model does not differ much from the practices of traditional pawnshops over the centuries. In fact, pawnshops originated in China, dating back to some of the earliest forms of financial primitive currency in the 5th century AD.

Ancient Chinese pawnshops

With the development of the financial industry and the emergence of various intermediaries, the pawnshop model has given way to credit lending. The main difference between credit and pawnshop business models is the relaxation of LTV (TVL > 100%), meaning lenders are willing to provide loans that exceed the value of the collateral. Lenders will conduct due diligence on borrowers based on available information and assess their risk of default. This requires non-transferable identities and reliable data to prove that identity.

The current state of DeFi mimics crypto pawnshops, facilitating over-collateralized lending through autonomous protocols, thus repeating the script of the dark ages.

However, the industry will move forward, and below we look at the current situation and what may happen in the future.

1. Crypto Pawnshops

As mentioned above, pawnshops will extend loans based on LTV below 100%. The two main business model parameters for pawnshops are LTV and collateral quality, with LTV depending on the quality of the collateral.

In the first generation of crypto pawnshops, a borrower's creditworthiness is reflected solely through the quality and quantity of collateral, but in real life, many other factors must be considered to assess a loan applicant's creditworthiness. However, in DeFi, due to the pseudo-anonymity of transactions, the situation is different.

Good collateral possesses multiple qualities. According to the European Central Bank (ECB) framework, good collateral should have liquidity and safety. Undoubtedly, BTC and ETH are the most commonly used types of collateral in DeFi lending protocols. Aside from volatility, they seem to meet the above standards and can mitigate volatility through immediate liquidation via decentralized exchanges with stable liquidity.

• NFTs as Collateral

The next frontier for DeFi pawnshops is currently undervalued and illiquid crypto assets, such as NFT attribute assets.

NFTs saw explosive growth in 2021, and with the surge in NFT owners, several teams have begun to establish collateral protocols for NFTs, such as NFTfi, Stater (beta product), and PawnFi (just a Twitter handle, no product yet).

The problem with NFTs lies in the lack of fixed price supply, low liquidity, and opaque valuation. When prices drop, the system struggles to liquidate collateral immediately. Given the secondary nature of the market, understanding when prices truly drop is also challenging.

One solution to the lack of liquidity and price discovery is to tokenize NFTs into ERC20s and trade them on DEXs. NFTX and NFT20 are doing just that.

Of course, there are many types of NFTs, and the question is which type of collateral will first be used as collateral for DeFi loans. Based on the collateral quality mentioned in the aforementioned ECB document, the most liquid and easily valued NFTs will be prioritized as collateral in DeFi lending.

As previously mentioned, tokenized NFTs will first become collateral, followed by NFTs from games and the metaverse. This is because gaming assets typically have specific digital utility (higher-level skins, stronger weapons, etc.) and are more likely to have continuous price supply and deeper liquidity within their respective ecosystems. However, NFTs intended for use as gaming assets should not be isolated from their corresponding gaming ecosystems.

• Real-World Assets

Following traditional crypto assets and NFTs, the next generation of collateral is tokenized real-world assets (RWAs). Fiat currencies, real estate, gold, securities (stocks and bonds), invoices, tickets, etc., can all serve as collateral for lending on the blockchain.

Fiat currencies and real estate have been tested as collateral in DeFi lending protocols (USDC in MakerDAO and RealT tokens in Aave). In addition to the standard quality of eligible collateral, tokenized RWAs are also affected by specific risks arising from the tokenization process.

1) Is there an issuing entity behind USDC, such as Circle Internet Financial Limited?

2) How transparent is the issuing entity?

3) Are the reserve assets auditable?

4) Where are the assets actually held in real life (banks, custodians, etc.)?

5) Do these assets require any specific storage or maintenance procedures (e.g., gold)?

6) If the issuing entity is a country, what is the political risk?

7) In the event of borrower default, is there a reliable legal enforcement framework to rely on?

Additionally, certain RWAs may need to comply with special rules, such as KYC/AML and transferability requirements. These will affect the scoring of such assets for collateral purposes and may even render them non-tradable globally.

Therefore, the transition of crypto pawnshops from over-collateralization to more capital-efficient lending must meet two conditions: digital identity and digital reputation.

2. Cryptocurrency Credit Institutions

The transition from the pawnshop business model to credit lending (under-collateralized loans) requires: the borrower's non-transferable identity and some information regarding their creditworthiness (credit score).

This identity should not be transferable; otherwise, lenders will never be able to determine who is behind that identity and whether the credit score truly belongs to that individual.

• Corporate DeFi Lending

From a legal perspective, there are two types of actors in the world: natural persons (individuals) and legal entities (companies). The former has existed for a long time, while the latter has only emerged relatively recently. One of the earliest legal entities was the Dutch East India Company (VOC), established in 1602.

In this sense, the age of a corporation is 1/750 that of a natural person. However, compared to individuals, companies are the first entities to obtain under-collateralized DeFi loans. Projects being developed in this field include: TrueFi, Maple Finance, Goldfinch, Centrifuge.

These protocols resemble traditional banks more closely; they originate from borrowers, assess their creditworthiness, and sign legally binding loan agreements.

The main difference between these protocols and conventional banks is the source of funding. Banks obtain funds from deposits, while these protocols source financing from anonymous (e.g., TrueFi) or non-anonymous (e.g., Centrifuge) local cryptocurrency investors.

The borrowers in these protocols are typically well-known brands in the crypto industry, such as crypto exchanges, miners, and crypto funds. This can serve as a proxy for credit scoring, ensuring that value remains aligned between borrowers and lenders.

Whether corporate DeFi lending will achieve measurable goals depends on whether these protocols can meet demand and supply.

From the demand side, the question is whether these platforms will be able to initiate enough corporate borrowers willing to obtain cryptocurrency loans at given interest rates.

Potential crypto DeFi borrowers are likely to be companies (or DAOs) that cannot obtain loans in traditional financial markets (banks, bonds, etc.). Additionally, crypto DeFi borrowers may use loan proceeds for crypto-related purposes.

These two factors automatically place such borrowers in a high-risk category, making credit scoring a key factor.

From the supply side, the focus is on whether the interest rates offered by lending protocols are sufficient to attract crypto investors. Clearly, the rates cannot be too high, as this would scare off borrowers. To compensate for this, DeFi protocols operating corporate lending can offer their native tokens to liquidity providers.

We are unlikely to see significant growth in corporate DeFi lending, but there is certainly room for it. The growth of these protocols is limited by the speed at which new borrowers are initiated, which requires business development teams to market and conduct traditional due diligence on borrowers. Competition among these platforms will be very similar to competition in the traditional world, with some protocols potentially hiring executives from banks.

The implication is that when this cycle reverses, we may see the first defaults on corporate crypto loans in the coming years. This will bring interesting legal challenges.

Someone will have to explain to a judge how decentralized autonomous organizations (DAOs) issue loans from an anonymous group of creditors.

• Personal Consumer Loans

Unlike corporate DeFi loans, providing under-collateralized loans to individuals in a decentralized manner is more complex, primarily because the cost of underwriting a consumer loan far exceeds the expected returns from issuing the loan.

Related costs include due diligence, credit risk assessment, and potential enforcement costs. Unlike corporate borrowers, individuals typically seek smaller loan amounts, making it economically unfeasible to spread such costs across loan applications.

Moreover, in many jurisdictions, consumer loans are also a regulated business, so successfully implementing DeFi consumer loan protocols is likely to attract the attention of regulators.

A well-known example in this field is Teller Finance (currently in testing), which promises to allow unsecured consumer loans. How does it work? By connecting to potential customers' bank accounts and conducting credit assessments based on account history. This is not much different from how it works today in TradFi.

When granting access to bank accounts, loan applicants will also disclose their identities, which may deter the current generation of DeFi users.

Due to the lack of any other native DeFi credit scoring, loans must rely on bank account history. If there were a reliable credit score associated with a specific loan applicant, Teller would be happy to extend DeFi loans without connecting to customer bank accounts.

This brings us to the concepts of digital identity and digital reputation, which are essential for the development and full potential of unsecured DeFi loans.

• Digital Identity and Digital Reputation

The reason collateral must exceed the loan amount today is the lack of concepts such as digital identity and digital reputation, leading to a trust deficit that can only be addressed through over-collateralization.

Reputation encompasses all data points related to identity, allowing interested third parties to assess default risk and calculate the creditworthiness of a specific borrower. In centralized finance, a borrower's reputation is typically assessed based on the following criteria: pay stubs, bank account transaction history, credit scores issued by credit bureaus, savings balances, past defaults, the number of recent credit inquiries, and lack of criminal records.

All of the above exists in centralized registries maintained by entities such as police and banks. As all this information eventually enters the blockchain network, we may see the emergence of purely digital credit scores. Initially, such digital credit scores will replicate off-chain scores, placing greater emphasis on financial factors.

However, as the Web 3.0 technology stack continues to develop and the metaverse emerges, digital factors may become more prominent in assessing creditworthiness. These factors may include:

1) The number of followers in any specific social network

2) The value of content and other IP addresses created by the borrower through NFTs (verified or owned by the borrower)

3) The borrower's history of interaction with DeFi (your wallet is not only your resume but also your credit score), including participation in governance of major protocols

4) Acts of kindness through participation in grant programs (like Gitcoin)

5) Rankings in on-chain virtual worlds

6) Guarantees from other on-chain entities (such as individuals or protocols)

Effectively using such factors for credit scoring requires decentralized identities rather than national IDs. Several projects are attempting to address this issue, such as Ceramic, BrightID, and Idena. The team behind Spectral Finance seems to be aggregating wallets into a single NFT and assigning an on-chain credit score to it, but it remains unclear how to handle the implementation of non-transferable identities.

3. The Future of DeFi Lending

Let’s summarize. Today's DeFi lending is primarily based on over-collateralized loans, using crypto blue chips as collateral.

The next iteration of this business model is tokenized NFTs and RWAs. Liquidity and price discovery mechanisms are crucial here.

Beyond that, considering the economics of the underwriting process, under-collateralized loans will first be offered to corporate borrowers. This is the most feasible approach in the short term. However, for individual borrowers to obtain under-collateralized loans, the market needs to address the issues of decentralized identity and on-chain reputation.

Despite the surge in DeFi loans, we are still in the early stages. With the introduction of digital identity and on-chain reputation, DeFi will begin to support more collateral types, more institutions, and more forms of loans.