In the analog world, we tend to define borrowed money by its purpose. Loans are preceded by labels – home, college, business – and represent investments with tangible goals.

We want our homes to rise in value; our diplomas to facilitate well-paying jobs; our businesses to grow. It’s simple logic: we borrow when we need to fill deficits, in the hope that the money will seed our future success.

However, this rationale falls flat on the blockchain. Loan agreements aren’t as related to real-world problem solving – in fact, most people who take part in DeFi loans never take their borrowed money offline, let alone apply it to actual spending. .

The loan market is not what you might call approachable neither for conventional borrowers.

“Challenge [lending] is not for the faint of heart ”, Reuters Tom wilson written in August of last year. “Borrowers are usually traders who take out loans, for example, ethereum, and then use the coins to trade on various exchanges against other cryptocurrencies. They then aim to repay the loan and pocket their profits, comparable to short sellers in the stock markets. ”

For these borrowers, loans are generally used to generate income, rather than a convenient method of solving a problem or a goal.

“I trade for fun,” crypto enthusiast Antoine Mouran told Wilson in an interview. Mouran, a student in Lausanne, borrows USD coins from Aave and uses these funds to exchange loan coins. “My wallet is a few thousand dollars.”

But the question is: will the only people benefiting from blockchain-based loans be investors like Mouran? Or could DeFi-based loans also open up new avenues of opportunity for conventional borrowers who wish to apply the borrowed money to real-world issues?

This is a question that deserves to be asked more than ever. In the aftermath of a global pandemic, countless small business owners come face to face with a long-suspected truth: Traditional financial institutions won’t always be there to catch up with them in the event of a downfall. According to Biz2Credit Index of Small Business Loans, the big banks approved only 13.2% of the funding requests they received in January 2021 – a double-digit drop from the same period in 2020.

Of course, finding financial support was not easy even before the pandemic; last year, the Federal Reserve Small Business Credit Survey found that only 51% of small business owners received the full amount of financing they requested in 2019, and 20% chose to decline all or part of the financing because of sky-high interest rates.

It has become clear that the traditional financial products offered by centralized institutions no longer meet the needs of today’s business owners. They need low-value loans that can be obtained flexibly and quickly, without the high interest rates or low approval rates so often posed by centralized banking entities.

DeFi has enabled developers to create such sophisticated, customizable and accessible microcredit products. But more than mere convenience, a shift to blockchain-facilitated loans would democratize lending and put more agency in the hands of consumers who have traditionally had no say in the design or accessibility of their products. loan.

It’s an intuitive solution with a seemingly indisputable stumbling block: oversizing.

The high cost of anonymous borrowing

Even among blockchain enthusiasts, pitching DeFi loans as a crucial financing solution for cash-strapped small business owners would likely not elicit an overwhelmingly positive response.

Anonymity comes at a price – and in the case of DeFi loans, that price is over-sizing. When a person applies for a conventional loan, their banker performs a credit check and an income check to confirm that the person can afford to repay the amount they are borrowing.

On the blockchain, user anonymity naturally prevents such reviews and forces lenders to find another way to protect their investments.

The solution, usually, is over-collateralization: the borrower deposits assets as collateral that exceed the total value of the loan. This equity capital, so to speak, can be shockingly high. For example, those wishing to take out a loan from Dai on MakerDAO must guarantee at a minimum of 150%.

Having said that, many choose to go down, even more, to avoid triggering liquidation penalties, i.e. fees incurred when the price of ethereum drops, bringing the value of an investor’s collateral below the mandatory threshold of 150%.

According to DeFi Rate statistics, the average collateralization ratio on all platforms reaches a huge 348%.

Let’s put this in context for our theoretical small business owner. If they wanted to withdraw $ 2,000 to cover a shortfall and were following DeFi Rate’s average guarantee ratio, they would have to deposit $ 6,960 just to get the loan.

Even if they had this money, it seems unlikely that they could justify freezing these funds as collateral. Unlike players like Mouran, who are not looking so much for financial support as a springboard for investment, most companies do not have “a few thousand” to put up as collateral.

As David Arnold of NPR explained in an article last year:

“A lot of small businesses operate a lot like people who live on a paycheck without a lot of savings.”

And it’s true – according to research conducted by the JP Morgan Chase Institute, small businesses typically only have a month of cash on hand to keep the lights on. These are not consumers who can afford to oversize. To take advantage of DeFi loans, lenders should first bypass the need for over-collateralization.

Eliminate the need for oversizing

At first glance, eliminating oversizing appears to be a failure. After all, the conventional model backed by a guarantor – which reduces or waives the collateral based on a person’s credit – flies in the face of DeFi’s philosophy of anonymity. If lenders started asking for personal financial information or obtaining personal credit reports from centralized bureaus, they would effectively be breaking a fundamental tenet of blockchain-based finance: confidentiality.

However, there is a means of establishing creditworthiness while preserving the anonymity of the borrower. The answer lies in the creation of identity layer protocols which whitelists a user’s unified wallet address and assesses their credit behavior uniquely via this address and any other whitelisted address the user chooses to include.

This protocol would bring together only financial information required to establish a certain reputation for credibility and would not collect any sensitive personal information that could be used against the borrower in the event of a disagreement or default.

Like Jo Ann Barefoot, Compliance Consultant and Former Deputy Comptroller in the Office of the Comptroller of the Currency once commented for American banker, “There is no doubt that the concept of blockchain, with its power to avoid chain duplication and discrepancies, holds great promise for identity. On a distributed ledger, everyone can trust that what is in the ledger is there and is the only version of it.

However, this solution may not be sufficient to waive the high warranty requirements entirely. To this end, lenders and borrowers may need to establish credit delegation agreements through smart contracts.

These contracts would establish all-important terms and conditions relating to interest rates and conditions as open law, thus providing an unchanging benchmark.

Taken together, these features could provide lenders with sufficient insurance to reduce their collateral requirements to levels more accessible to business owners. However, affected borrowers can further reduce their personal risk load by participating in community microcredit. Under the deal, lenders would provide liquidity to pool dozens of low-value “microloans”.

Within this community lending ecosystem, risk is shared and therefore no single lender bears the burden of risk alone.

Low collateral and blockchain facilitated microcredits are both possible and worth pursuing. Under the deal, cash-strapped business owners would not only have access to much-needed financing, but would also have a say in the design of their financial products – a voice centralized banking systems rarely allow. , if ever. Lenders, for their part, would be able to profit from these loans. and inject much needed innovation into a lending ecosystem that has too long been dominated by centralized financial giants.

Is blockchain-based microcredit a dream? Today, yes, but tomorrow it could very well provide financial support for real-world aspirations.

Guest post by Ankitt Gaur from Easyfi.network

Ankitt Gaur is the Founder and CEO of Easyfi.Network, a DeFi Layer 2 lending protocol for digital assets powered by the Matic Network. He is also a Blockchain Visiting Faculty Member at the Institute of Chartered Accountants of India (ICAI).

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