Read full article at The Capital.

Traditional Lending Vs. DeFi Lending — Which Offers The Best For Borrowing Money?

DeFi protocols are competing with the traditional financial service sector. It is a fast-growing industry in the cryptocurrency space based on DApps (Decentralized Applications) that utilize smart contract execution primarily on the Ethereum blockchain. The TVL (Total Value Locked) in DeFi is worth $82.18 Billion (as of late September 2021), driven by lending and decentralized exchanges (DEX). There is plenty of capital flowing into liquidity that is providing a financial instrument that creates new opportunities for financing.

Lending has a particularly huge potential for DeFi (valued at $40.28 Billion), made available from lending protocols like Aave, Maker DAO, and Compound Finance. It is also being offered as a service by fintech companies like Celsius, BlockFi, and Nexo. Some of these protocols offer fair rates to borrowing money which can be converted from crypto to fiat. Users can also deposit money into an interest-bearing account for lending purposes.

One of the main features of DeFi lending is that it offers different requirements compared to traditional creditors. Credit providers who lend money can finance individual and business needs, but there are plenty of requirements. One of the most important requirements from lenders is that the user must have a good credit score (FICO score of 640 and higher in the US). The higher your credit score, the more capital there is available for borrowing. DeFi does not have those strict requirements to be submitted or collect personally identifiable information (PII) from its users. A user can quickly borrow money (no questions asked) by using cryptocurrency as a form of collateral.

Traditional Lending

When lending money to borrowers, banks and other creditors charge a usual interest rate based on their credit analysis. A borrower can use a form of collateral to secure a loan. The collateral can be the person’s automobile or house, which is in itself the valuation of their personal asset. Without collateral, or an unsecured loan, the borrower is often given a higher rate of interest and limited funds can be borrowed. The debt owed is then added with the interest, compounded depending on the terms.

For a simple $30,000 non-collateral loan, let’s assume that the interest amount to pay is at 36% of the principal amount:

“Acme Bank” -> 30,000 + 0.36(30,000) = 40,800

Interest Owed = 10,800

The lender will allow for an installment of payments which can be made monthly, quarterly, semi-annually, or depends on the terms of the loan agreed between the two parties. The higher a borrower’s credit score, the lower the amount of payments.

If a borrower was approved at 36% interest (meaning low credit score), the $30,000 they borrowed can be paid on monthly installment at $1,374.11 per month for a term of 36 months (3 years). Creditors will offer a much better rate to those who have an excellent credit score (800+ and higher). For the same amount borrowed, borrowers with excellent credit scores can pay at a monthly rate of 10% which is $968.02 per month.

This is just a theoretical example but is based on how lenders provide capital for borrowing. It requires approval by the lender, who uses criteria based on financial rules and regulations.

DeFi Lending

Using an example based on Maker DAO, all that a borrower needs to provide is their digital asset as collateral. There is no KYC (Know Your Customer) or third-party approval involved. Once the collateral is provided, users can then borrow against it using what is called a CDP (Collateralized Debt Position). The debt payment is the amount value of the CDP ratio which can be as high as 150% (e.g. $20,000 for $30,000 worth of locked ETH). Overcollateralization is by design in order to secure a loan repayment from the borrower.

In Defi, the collateral deposited is not what determines the amount a user can borrow. It depends on the LTV (Loan-to-Value) ratio of how much a user wants to borrow against their collateral. In Maker DAO, this is determined by the CDP. The more valuable the digital asset, the higher the risk if the value drops. Borrowers must make sure they can repay the loan or add more to their collateral value to offset liquidation by the protocol.

The lending protocol will issue the amount you can borrow in the form of a stablecoin token. In Maker DAO, that would be in the form of the DAI stablecoin. You only have to pay back the amount of DAI (pegged 1:1 to fiat currency valued in USD) that can be released based on the ratio. There is also no actual term as borrowers can pay back to reclaim their collateral at any time.

In this example, let us say a user wants to borrow $30,000 from Maker DAO. The borrower would have to provide collateral at a 150% CDP ratio.

“Maker” -> 30,000 * 1.5 = 45,000.00

The collateral to deposit into a CDP must be worth $45,000. This can be in the form of ETH (Ether) which is the most popular form of collateral used to generate DAI. This will then be locked into a CDP smart contract on the MakerDAO network.

For the amount of $45,000, the amount of $30,000 is issued in DAI. The expectation from the borrower to repay the loan is based on good faith, but remember that there is a collateral locked by the lending protocol.

When repaying the loan, Maker charges what is called a stability fee. If the fee is 6%, then:

Interest Owed = 30,000 * 0.06 = 1,800

If the borrower cannot repay the loan or decides to default, their collateral will be liquidated. On some DeFi protocols, the collateral can be liquidated if the LTV ratio exceeds a certain threshold. This can happen if the value of the deposited collateral falls in price based on market value.

Comparison Analysis

From both examples, we assume the borrower does not have a good credit score when borrowing the amount of $30,000. Comparing the difference, you pay less interest for the same amount of money borrowed from a DeFi lending protocol. You have to pay “Acme Bank” $10,800 in interest, while you only pay $1,800 to “Maker.” The difference in interest is what a DeFi borrower saves, which is $9,000.00.

A person who borrows from the bank will owe $9,000 more than if they had borrowed from a “Maker.”

Ratio = 1/6

For every dollar you pay to “Maker,” you pay $6 more to the bank. Banks will make $10,800 from interest payments, while the “Maker” gets $1,800 from the accrued interest on the stability fee. It seems banks are taking more money from interest based on their policy calculations.

This is just an example, not an actual proportional comparison. What you put as collateral to a bank doesn’t exactly equate to the same when putting into cryptocurrency. This does highlight how decentralized lending can save more than from a traditional financial institution.

If we look at it from face value, it seems that lenders in the traditional finance space (including banks) are just taking too much money from borrowers. There is actually a reason why they do that. Lenders like banks collect more money due to their organization. The profits earned from revenues on loans go to pay board members and stock holders. Large financial institutions in the private sector have a profit motive which is why interest is higher.

DeFi is a decentralized finance protocol. It is not an actual entity or institution that has board members and stockholders. Instead, you have token holders (e.g. MKR token for Maker DAO). It serves as a platform for facilitating transactions like lending. The token holders, who are a decentralized community, benefit from the fees collected on loan repayments. Anyone can be a token holder on the platform by exchanging DAI for MKR. As an MKR holder, a user is like a board member since the token grant them voting rights to determine the development and policies of the protocol.

The reason for holding MKR is a form of incentive. While banks have a small group of individuals who form the executive board that dictates policies, MKR holders are a large community that participates in digital governance. Therefore, DeFi protocols are based on a form of decentralized digital democracy in which there is a larger group that votes policy based on the majority, while banks are more like a centralized authority where decisions are made by a few people at the top of the organization.

If a borrower has requirement difficulties to secure a loan from traditional lenders, DeFi is an option. In DeFi, there are no documents required or questions asked. It does require collateral though, in order to obtain a loan from a DeFi protocol. The borrower would need to have a digital asset like ETH or Bitcoin (BTC) to lock into a smart contract with an LTV ratio. Otherwise, a borrower has the option to pay higher interest with an unsecured loan from traditional lenders.

Final Thoughts And Takeaways

DeFi protocols for lending offer more opportunities for financial inclusion. This feature makes it an attractive alternative to traditional financial instruments. Borrowers do not need approval based on submitted documents or credit scores to obtain loans. DeFi only requires collateral in the form of digital assets (i.e. cryptocurrency), and It is all automated by smart contracts. There are no credit advisors or agents in DeFi, so borrowers will have to independently manage their own loans. If you have the collateral, then DeFi can be an easier way to obtain a loan since it doesn’t require any third-party approval.

An important consideration is to make sure that the value of the collateral doesn’t fall below a certain level, or it could be automatically liquidated. That is the risk involved with DeFi. It becomes riskier the higher the LTV ratio when borrowing against the digital asset. If the collateral value is above the threshold, the borrower does not need to make a payment. If the threshold is reached, borrowers will either have to add more to their collateral or pay off the loan if they want to reclaim it.

Innovative financial products like those used in DeFi will compete with traditional financial institutions. This can result in a more competitive market, as fintech and traditional lenders enter the space to begin offering similar products. This will benefit users even more since there will be greater options available. There is no definitive answer on whether one is better than the other, but it all depends on the borrower’s requirements. DeFi is just an alternative to what is available.

The key takeaway here is if there will be a regulation of the DeFi space. It will all depend on how regulators and agencies like the US SEC (Securities and Exchange Commission) or FATF (Financial Action Task Force) will view DeFi lending since it uses cryptocurrency. Perhaps they see its potential as positive to the economy in the overall micro perspective, so that could help build further growth.

First Published In The Capital — 9/28/21

(Photo Banner Credit By Andrea Piacquadio)

Disclaimer: This is not financial advice. The information provided is for educational and reference purposes only. Do your own research always to verify facts.

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Traditional Lending Vs. DeFi Lending — Which Offers The Best For Borrowing Money? was originally published in The Capital on Medium, where people are continuing the conversation by highlighting and responding to this story.

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