Decentralized Liquidity Protocols: The Future of Lending and Borrowing in DeFi

By Alexander Szul, advisor at Hover

The decentralized finance (DeFi) space is undergoing rapid evolution. From the first publicly traded company to deploy a blockchain in BASE, to multiple new US bills being introduced for crypto regulation, the nature of blockchain finance is approaching a new era of growth.

This bear-market renaissance reaches down even to base-layer applications themselves. These decentralized liquidity protocols are fundamental market primitives that play a crucial role in how on-chain activities, such as trading, can occur. Their benefit? There is no need for financial intermediaries like banks or brokers.

Decentralized liquidity protocols not only facilitate trading but, via automated lending platforms, provide users with the ability to access yield-generating and borrowing products. Lenders earn interest on their deposited assets, while borrowers can access funds by locking up collateral.

These money markets (not to be confused with traditional finance money markets) are transforming the traditional lending and borrowing landscape by replacing red-tape with efficiency and ease of use. Users are protected by the immutability of blockchain records and pseudo-anonymity, while higher levels of financial justice and inclusion can be attained, enshrined, automated and executed via smart contracts.

Disrupting traditional lending and borrowing

To understand how DeFi money markets reshape the current lending space, it is valuable to understand what is necessary for taking a loan in the first place. It requires supplying personal identification, proof of employment, and information regarding our other debts and expenses to open an account. Additionally, a down payment may be required, the execution of a credit check, and an evaluation of our debt-to-income (DTI) ratio. Simply put, gaining access to traditional lending and borrowing is a highly involved process.

Blockchain-based services provide an elegant alternative to all of these steps. One can begin with just a free cryptocurrency wallet. In place of personal identification, all that is required is the wallet’s address. Proof of funds on the blockchain ledger replaces proof of employment. Instead of DTI ratio evaluation, the smart contract can simply hold a deposit as collateral. These innovative considerations reshape the way lending operates into a more transparent and efficient process.

In conventional loan agreements, borrowers are typically obligated to repay their loans over a period of time. However, in a blockchain-based lending scenario, loans can be structured in a way that they are automatically repayable to the lending protocol within a single block. This instantaneous repayment upon specific conditions being met can enhance efficiency, reduce the risk of default, and simplify the repayment process. If a borrower chooses to repay over time, money market loans are termless meaning they only need to be repaid when the borrowed interest accrues to a certain amount. The more interest is paid off, or collateral that is deposited, the longer the borrowed funds can be held.

How do DeFi lending services consider risk?

Both the personal risk of participants and overall systemic risk are algorithmically covered in these lending protocols.

Over-collateralization

Unlike in traditional lending, where loans are often "under"-collateralized, decentralized protocols take an "over"-collateralized approach. For instance, Bob wants a loan of $5000. In a traditional scenario, a bank may ask for a 10% down payment. With a DeFi protocol, he may be required to deposit assets worth 200% of the loan amount, which means collateral valued at $10,000.

The concept of over-collateralization is designed to mitigate the risk of default and address the pseudo-anonymity implicit within cryptocurrency markets. Since these protocols operate in a trustless environment, the provision of more collateral than the loan ensures that lenders, and the protocol itself, are well-protected against losses.

DLT and smart contracts

The much-vaunted qualities of distributed ledger technology (DLT) afford many protections to participants; chiefly, transparency, immutability, and security of transactions.

The protocol’s self-executing smart contracts automate and enforce lending parameters, ensuring that lending terms, interest rates, and repayment schedules are executed exactly as defined in the code. In addition to cryptographic security, they are publicly auditable meaning that all transactions and changes can be verified by anyone.

Automated Loan Underwriting and Liquidation

Systemic risk is covered via automated loan underwriting and liquidation. Automated loan underwriting is implemented via smart contracts, with borrowing limits based on predefined rules and criteria. When a borrow limit is exceeded either from excessive interest or the devaluation of collateral, the contract opens up a borrowers collateral for liquidation. When executing a liquidation, a portion of collateral is siezes by the contracts, auctioned to the public for a sale, and the proceeds pay off the outstanding debt.

Automated liquidation mechanisms mitigate the risk of default by borrowers and ensure that lenders are repaid even if the value of the collateral drops significantly. Such mechanisms are an integral part of lending protocols, providing a safety net for lenders and helping maintain the stability and security of the platform. They reduce the risk of loss due to market volatility and ensure that loans are properly collateralized throughout their duration.

Systemic benefits

Decentralized, non-custodial money markets provide a number of significant benefits:

• Access to cost-effective capital for low-credit and unbanked market participants.

• Elimination of high-risk, over-leveraged positions and poorly collateralized financial instruments.

• Consistent return rates for depositors of stablecoins.

• Provision of liquidity to decentralized exchanges in the event of a market downturn.

• Increased solvency across several, multi-billion dollar money markets.

These protocols are revolutionizing the way financial services are accessed and provided. They offer users a secure, transparent, and efficient way to lend, borrow, and earn returns on their digital assets, all while maintaining control over their funds and minimizing counterparty risk.

Author Bio

Alex Szul graduated from University of Pittsburgh. In 2021 Alex became a co-founder at Rome Blockchain Labs Inc., a global research and development consortium building next generation blockchain technology. Alexander Szul, a visionary entrepreneur and co-founder at Rome Blockchain Labs, is dedicated to establishing a future of financial transparency and integrity in the blockchain space. With a strong background in managing technical projects and leading sales processes, Alexander has emerged as a distinguished leader in Rome Blockchain Labs. He has successfully constructed an international, collaborative team across ten DeFi networks and is now committed to developing innovative solutions that bridge the gap between traditional finance and DeFi.

LinkedIn: https://www.linkedin.com/in/alexander-szul-80073690/ 

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