The concept of Decentralized finance (DeFi) is the most interesting in the blockchain space right now.
Let me explain to you what this is, in case you have no idea. A DeFi is a decentralized platform built on the blockchain that offers financial services that you would otherwise access only from a centralized financial institution like a commercial bank.
The concept seemingly forms the next step in the dismantling of the legacy financial system, which benefits only a few.
The most developed product of the DeFi is its credit offering. You can borrow money from a DeFi platform at lower interest rates than what you usually pay to traditional banks. For example, on Compound Finance, one of the top-performing DeFi, you can pay an annual percentage yield of as low as 5%. Compare that to bank loan interests that can be as high as 20% in some countries.
On the other hand — and this is the strongest selling point of DeFi — you can lend money on the platform, and you will receive interest a lot higher than what a bank would pay you if you saved with them. You can fetch as much as 7% interest on Compound Finance, for example. Meanwhile, your typical commercial bank can hardly pay you more than 1%.
How DeFi works
What the DeFi application does is to cut out the middle-person in the lending and borrowing transactions. The app collects money from those who have more than they need right now and lends it to those who need to borrow.
A smart contract on a blockchain — Ethereum in the case of Compound Finance — guides and manages the entire process. That means no one really has an arbitrary control of the system, and in particular, the money being exchanged. So, no part of it goes to a corporation, and the risk of theft is significantly reduced.
Meanwhile, it is upon a smart algorithm to determine the interest and fees that the borrowers pay, and lenders get depending on the data it receives from the markets (primarily demand and supply volumes).
In addition to Compound Finance, other successful DeFi platforms include MakerDao, Fulcrum, and Dy/Dx. There seems to be a lot of money being processed in the form of credit on these platforms. For example, Compound Finance has processed transactions worth over US$1 billion.
All seems to be going well, and more people are coming on board both as investors (lenders) and borrowers. However, there is a critical question that needs to be answered satisfactorily if at all, we are going to believe that DeFi has a bright future.
The problem with DeFi
And the question is, why would anyone even consider borrowing from a DeFi?
Let me give the question some context.
To borrow from any of the major DeFi applications, you need to provide collateral that would be locked in a smart contract. As of the time of writing this post, the collateral you can provide has to be a blockchain asset or token.
Meanwhile, you receive the loan itself in the form of another blockchain asset. For example, on Compound Finance, you can lock ETH as collateral and receive the credit in DAI (a stable coin on the Ethereum blockchain).
Now, you can only borrow up to 75% of the value you have locked as collateral. For example, if you have US$100 worth of ETH as collateral, you can only borrow up to US$ 75 worth of DAI.
Given the volatility of most crypto assets, you always stand the risk of being liquidated. That means that if for whatever reason, the value of ETH at the marketplace drops significantly and soon what you have locked as collateral is worth less than the loan you took, you will lose the collateral, and the loan is deemed settled.
Now, it does not make sense why you would provide your ETH as collateral while you could easily and instantly convert it to DAI on an exchange, and do whatever you needed to do with the money.
DeFi only makes sense in one way.
The only time it makes sense to borrow from DeFi is if you are speculating. For example, you lock your ETH as collateral and borrow DAI against it with the anticipation that the value of your ETH is going to grow, and you can sell your gain and settle the loan. And this makes even more sense when you borrow in a stable coin like DAI, which pegged to the US dollar.
Otherwise, for people needing to borrow for other reasons like funding small business operations, especially in the developing world, it does not make sense at all. And the fact that accessing data secured loans is now a reality does not help the cause.
Indeed, at the primary level, DeFi applications are competing with centralized digital lending applications like Branch, Tala, and mobile money services. These services do not require users to provide any collateral for security. Indeed, all these apps require for securing a loan is access to a user’s data. They use this information to calculate creditworthiness.
For example, in Kenya (I am based), you can sign up on one of almost a dozen lending applications on your phone (including simple feature phones) and get a loan approved instantly. Mobile loans have become so easy to access, according to an association of Kenya credit bureaus, that 19 million Kenyans have an outstanding loan. About 40% of these have multiple mobile loans.
Indeed, it is users who access a long list of lending applications from which to borrow who are most likely to ask the question ‘why should I consider taking a loan from a DeFi?’
Like customers of other types of products and services, what those who ‘buy’ credit care the most about is seamless user experience. Decentralization and curtailing the power major centralized financial institutions are accumulating are not things they think most about.
Lower interest rates could be something that can attract them to DeFi. However, having to deposit collateral before they borrow is something that most likely will not make sense to them, especially when the other digital lending platforms are not asking for any.
Indeed while the lending part in the DeFi architecture has a great offer, in my opinion, the same cannot be said of the borrowing side. It probably needs some redesigning.