Author:equilibrium
Translation: Shan Ouba, Golden Finance
As the cornerstone of Internet finance, the vision of the on-chain lending protocol is to provide fair access to capital for individuals and businesses around the world, no matter where they are. This model helps to build a fairer and more efficient capital market, thereby driving economic growth.
Although on-chain lending has great potential, the current main user base is still crypto-native users, and its use is mostly limited to speculative transactions. This greatly limits the total market (TAM) it can cover.
This article explores how to gradually expand the user base and transition to a more productive lending scenario while addressing the challenges that may be faced.
The current status of on-chain lending
In just a few years, the on-chain lending market has grown from a concept to multiple market-tested protocols that have survived multiple volatile market conditions without generating bad debts. To date, these protocols have attracted $43.7 billion in deposits and issued $18.6 billion in outstanding loans.
Source: DefiLlama
Source: Artemis
Currently, the main sources of demand for on-chain lending protocols include:
- Speculative trading: Crypto investors use leverage to buy more crypto assets (for example, borrowing USDC with BTC as collateral, and then buying more BTC, or even cycling multiple times to increase leverage).
- Liquidity Access: Investors gain access to liquidity in crypto assets through lending without having to sell the assets, thereby avoiding capital gains taxes (depending on the jurisdiction).
- Arbitrage Flash Loan: An extremely short-term loan (borrowed and repaid within the same block) used by arbitrage traders to take advantage of temporary price imbalances in the market and create price corrections.
These applications mainly serve crypto-native users and are mainly speculative. However, the vision of on-chain lending goes far beyond this.
Compared to the $320 trillion in total global outstanding debt, or the $120 trillion in loans to households and non-financial businesses, the current $18.6 billion in outstanding loans on-chain lending protocols is a tiny fraction of that.
Source: Institute of International Finance Global Debt Monitor
As on-chain lending gradually transforms to more productive capital uses (such as small business financing, personal car or home loans), its market size (TAM) is expected to grow by several orders of magnitude.
The future of on-chain lending
To improve the practicality of on-chain lending, two key improvements are needed:
1. Expand the scope of mortgage assets
Currently, only a few crypto assets can be used as collateral, which greatly limits the number of potential borrowers. In addition, to compensate for the high volatility of crypto assets, existing on-chain lending often requires a collateral ratio of up to 2x or higher, further suppressing lending demand.
Expanding the range of acceptable collateral assets will not only attract more investors to use their portfolios for lending, but also improve the lending capacity of on-chain lending protocols.
2. Promote ultra-low collateral lending
Currently, most on-chain lending protocols use an over-collateralized model (i.e., the value of the collateral assets that the borrower must provide is higher than the amount of the loan). This model leads to inefficient capital utilization and makes many practical application scenarios (such as small business financing) difficult to achieve.
By adopting ultra-low collateral lending, on-chain lending can cover a wider group of borrowers, further enhancing its practicality.
The above improvements vary in difficulty, some are relatively easy to implement, while others will bring new challenges. However, the optimization process can be carried out step by step from easy to difficult.
In addition, fixed-rate lending is also an important feature in the development of on-chain lending. However, this problem can be solved by a third party assuming the borrower's interest rate risk (such as through interest rate swaps or customized agreements between lenders and borrowers), so this article will not discuss it in detail (there are already protocols, such as Notional, that provide fixed-rate lending services).
1. Expand the scope of mortgage assets
Compared to other asset classes in the world, such as the public equity market ($124 trillion), fixed income market ($140 trillion), and real estate market ($380 trillion), the total market value of the cryptocurrency market is only $3 trillion, accounting for only a small portion of global financial assets. Therefore, limiting the scope of collateral to a select number of crypto assets greatly limits the growth of on-chain lending, especially when collateral requirements are as high as 2x or even higher to compensate for the high volatility of crypto assets.
Combining asset tokenization with on-chain lending enables investors to more efficiently leverage their entire portfolio for lending, rather than just a small portion of crypto assets, thereby broadening the universe of potential borrowers.
The first step to expand the range of collateral assets may start with highly liquid and frequently traded assets (such as stocks, money market funds, bonds, etc.), which have less impact on existing lending protocols and lower modification costs. However, the speed of regulatory approval will become the main limiting factor for growth in this area.
In the long term, expansion into less liquid physical assets, such as tokenized real estate ownership, will offer significant growth potential, but will also bring new challenges, such as how to effectively manage debt positions on these assets.
Eventually, on-chain lending may develop to the point where mortgage loans are secured by real estate, where loan issuance, property purchase, and deposit of the property into a lending protocol as collateral can be completed atomically within a single block. Similarly, businesses can also finance themselves through lending protocols, such as purchasing factory equipment and depositing it into the protocol as collateral at the same time.
2. Promote low-collateral lending
Currently, most on-chain lending protocols use an over-collateralization model, where the value of the collateral assets that the borrower must provide is higher than the amount of the loan. Although this model ensures the safety of the lender, it also leads to inefficient capital utilization, making many practical application scenarios (such as small business working capital loans) difficult to achieve.
In the crypto industry, the initial demand for low-collateralized lending may come from market makers and other crypto-native institutions that still need financing channels after the collapse of centralized lending platforms (such as BlockFi, Genesis, and Celsius). However, most early decentralized low-collateralized lending attempts (such as Goldfinch and Maple) handled the lending logic off-chain or eventually turned to an over-collateralized model.
One new project worth watching is Wildcat Finance, which attempts to reintroduce low-collateralized lending while retaining more on-chain components. Wildcat only acts as a matching engine between borrowers and lenders, and lenders assess the credit risk of borrowers themselves, rather than relying on off-chain credit review processes.
Outside of the crypto industry, low-collateral lending has been widely used for personal loans (such as credit card debt, BNPL buy now pay later) and commercial lending (such as working capital loans, microfinance, trade financing, and corporate credit lines).
The biggest growth opportunities for on-chain lending products lie in markets that traditional banks cannot effectively cover, such as:
1. Personal lending market: In recent years, non-traditional lenders have continued to increase their share in the personal low-mortgage market, especially among low-income and middle-income groups. On-chain lending can serve as a natural extension of this trend, providing consumers with more competitive loan interest rates.
2. Small business financing: Due to the small loan amount, large banks are often reluctant to provide loans to small businesses, whether for business expansion or working capital. On-chain lending can fill this gap and provide a more convenient and efficient financing channel.
Challenges to be solved
Although the above two improvements will significantly expand the potential user base of on-chain lending and support more efficient financial applications, they also introduce a series of new challenges, including:
1. Dealing with debt positions backed by illiquid assets
Crypto assets are traded 24/7, while other liquid assets (such as stocks and bonds) are usually traded from Monday to Friday, but the price of illiquid assets (such as real estate and art) is updated much less frequently than this. The irregularity of price updates can make the management of debt positions more complicated, especially during periods of volatile market conditions.
2. Liquidation of physical mortgage assets
Although the ownership of physical assets can be mapped to the chain through tokenization, its liquidation process is far more complicated than that of on-chain assets. For example, in the case of tokenized real estate, the asset owner may refuse to vacate the property and even need to go through legal procedures to execute liquidation.
Given that on-chain lending protocols (and individual lenders) cannot directly handle the liquidation process, one solution is to sell the liquidation rights at a discount to local debt collection agencies, which will be responsible for handling liquidation matters. Such mechanisms need to be deeply integrated with the real-world legal system to ensure the feasibility of asset liquidation.
3. Determination of risk premium
Default risk is part of the lending business, but this risk should be reflected in the risk premium (i.e. the additional interest rate added to the risk-free rate). Especially in the field of low-value mortgages, it is crucial to accurately assess the default risk of the borrower.
There are a variety of tools available to estimate default risk, depending on the type of borrower:
•Individual borrowers: Web proofs, zero-knowledge proofs (ZKPs), and decentralized identity protocols (DIDs) can help individuals prove their credit scores, income status, employment status, etc. while protecting their privacy.
• Corporate borrowers: By integrating mainstream accounting software and audited financial reports, companies can prove their financial status such as cash flow, balance sheet, etc. on the chain. In the future, if financial data is fully on-chain, company financial information can be seamlessly integrated directly with lending agreements or third-party credit rating services to assess credit risk in a more trustless way.
4. Decentralized credit risk model
Traditional banks rely on internal user data and external public data to train credit risk models to assess borrowers’ default probability. However, this data silo effect brings two major problems: it is difficult for new entrants to compete because they cannot access data sets of the same size. Decentralized processing of data is more difficult because credit assessment models cannot be controlled by a single entity, and user data must remain private.
Fortunately, the fields of decentralized training and privacy-preserving computing are developing rapidly. Future decentralized protocols are expected to use these technologies to train credit risk models and perform inference calculations in a privacy-preserving manner, thereby achieving a fairer and more efficient credit assessment system on the chain.
Other challenges include on-chain privacy, adjusting risk parameters as the collateral pool grows, regulatory compliance, and making it easier to use borrowed proceeds for real-world utility.
in conclusion
On-chain lending protocols have laid a solid foundation over the past few years, but they have yet to truly realize their full potential.
The next phase of on-chain lending will be even more exciting: the protocol will gradually transition from crypto-native and speculative scenarios to more efficient and real-world relevant financial applications.
Ultimately, on-chain lending will help eliminate financial inequality and give all businesses and individuals, regardless of location, equal access to capital. As Theia Research summarizes: “Our goal is to build a financial system where net interest margins are compressed to the cost of capital.”
This will be a goal worth striving for!
