Losing Interest: The Flaws in DeFi Lending and a Plan to Make it Better

By Brent Xu, CEO of Umee

When first theorized, decentralized finance (DeFi) promised to create autonomous systems that would be cheaper, faster, more efficient, and more accountable than the finance systems of the past, facilitating greater participation in the financial ecosystem. Among DeFi’s envisioned use cases was an improved lending system built on this organizing principle. However, this vision is far from being realized.

The Problems with Status Quo DeFi Lending

Idealistic real world lending applications first envisaged by DeFi evangelists are yet to come to fruition. Instead, seduced by the tantalizing prospects of easy profits and dramatic short-term gains, the crypto lending ecosystem has acted as though it’s immune to the fundamentals that govern all debt markets. Rest assured, they are not, and periods of market stress such as the one we are experiencing now make that absolutely clear.

The economy-wide market contagion currently unleashed is severely damaging two types of crypto lenders, the ponzinomic and the reckless. Ponzinomic lenders are those with high risk bets on the discredited notion of perpetual exponential growth. For example, Anchor protocol, which promised 20% annual percent yield (APY) on staked UST, had little financial or statistical basis for promising such a rate. It was based on unreasonable expectations of exponential demand, and was clearly untenable.

Reckless lenders, many of which promise to utilize complex arbitrage strategies, carelessly pivoted to simple directional bets. In the case of Voyager, Three Arrows Capital, and Celsius these directional bets were – like those of the ponzinomic lenders – built on optimistic growth projections with little to no contingency planning.

Similar to the failed Web2 business concepts cleared out by the Dotcom Bubble of the early 2000s, neither of these models are likely to survive the current bear market. Those of us with an eye to the future should begin writing the rules for a DeFi lending market 2.0 – a lending market focused less on extracting maximal short term gains and more on developing a financial infrastructure based on real world utility. 

Why Lending Matters

Lending serves a vital societal function; sustaining the modern economy requires efficient allocation of resources and scalable capital investments. Imagine a company looking to build a factory. While the company may not have the capital necessary to self-finance construction, they know that the long term payoff of such a facility will exceed the short term costs. Therefore, the company will take out a loan with a specifically calculated interest rate based on both the time-value of money and the creditworthiness of the company in question. At the moment, this type of enterprise lending takes place almost exclusively within the traditional financial realm. 

How to Reform DeFi Lending

Decentralized lending cannot yet offer the same real world investment utility because it lacks the mechanisms for determining quantitatively derived interest rates. DeFi will not be able to evolve beyond its limited – and unsustainable – use cases. To make this leap, we need to develop blockchain-native versions of the bond market’s core facets: the yield curve and credit/debt ratings. 

The yield curve is seen by many as a primary indicator of economic expectations. As a result its accuracy is hugely important for a number of applications. In the traditional financial sector, U.S. treasury debt forms the basis of the yield curve offering so called risk-free rates for different maturities that ultimately reflect the time-value of money.

Other borrowing and lending rates—from individual borrowers taking out a 30 year mortgage all the way to public companies issuing 10-year corporate bonds to fund operations—trade at a spread to the risk free rate that applies to those same durations.

No different from the way traditional debt markets have operated for centuries, a functioning decentralized debt market will also require a risk free yield curve that will form the basis for other rates for borrowing and landing, staking or frankly anywhere digital assets are risked in exchange for some return. Additionally, once a yield curve is established, developers can build additional features for assessing the borrowing risk profiles of specific blockchains – tools such as rating mechanisms.

A Global Blockchain Debt Market

Most importantly, in the end, the influence of this decentralized rate curve will extend far beyond digital assets. Global debt markets, in their entirety, will migrate to blockchain. The benefits of enterprise scale loans in a decentralized ecosystem are simply unrivaled by the traditional lending market.

While traditional bank debt financing is bureaucratic, slow and subject to complex decision making and due diligence processes, decentralized lending works through self-executing smart contracts, which process loan requests rapidly and objectively. Furthermore, smart contracts are less subject to the adverse influence of human bias and prejudice. Ultimately, these efficiencies reduce the burden on both borrowers and lenders and alleviate friction that can limit financial activity.

I am certain that enterprises, individuals, and even governments will move towards trading debt on sovereign blockchains. However, systemic changes need to be made to the underlying industry. By starting with a term structure of interest rates and developing follow-on tools, DeFi borrowing and lending will have the maturity to realize its potential and fundamentally alter the world of finance.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.