Yesterday the Bank for International Settlements (BIS) published a bulletin on DeFi lending. On the one hand, it describes it as a “self-referential system fuelled by speculation.” However, it also recognizes the innovation it brings in terms of automating underwriting with smart contracts and composability.
That composability or so-called money legos enables customized financial products and is powerful for trade finance.
The bulletin authors have two major criticisms of DeFi lending: borrowers are anonymous, and the collateral is all cryptocurrencies. Collateral is required because of anonymity which means people who don’t have assets would also lack access to lending facilities which is not good for financial inclusion.
It points to a key role of financial institutions in gathering information on borrowers.
The over-collateralization of major Defi protocols leads to inefficient use of capital, and sticking to crypto as collateral leads to procyclicality. Higher crypto prices mean collateral values increase, allowing more borrowing feeding into price appreciation. And the reverse happens when prices fall.
In order to harness the innovation, the BIS wants to see large-scale tokenization of real world assets. And to address the financial inclusion issue, the use of identities needs to happen with the platforms coming under the regulatory umbrella.
While the report references one major platform launching a lending pool requiring identities (we’re assuming it means Aave), it does not mention the moves already in progress to address the issues it raised.
DeFi examples beyond the bulletin
One example is Centrifuge, which started in 2018. It creates lending pools for real world assets, including trade finance. Borrowers must provide their identities and a fair bit of information about their business to be presented to investors. While the total value locked is $87 million, that’s a tiny fraction of the billions on the big DeFi lending platforms.
Several more experimental offerings are targeting lending with little to no collateral by leveraging off-chain data, invariably using decentralized identity. Examples include Toyota-backed Teller and Reputation DAO.
There’s also the more traditional finance example in Singapore of JP Morgan, DBS Bank and SGX-backed Marketnode piloting DeFi with tokenized bonds as collateral.