Translation from original article in French published by L’Observatoire de la Fintech

by Charlotte Eli, Co-Founder and Chief Research Officer, Atlendis Labs and Professor Hervé Alexandre, Director of the Fintech Chair, Paris Dauphine University

Decentralized Finance, or DeFi, had a rather mixed year in 2022. The DeFi Summer of 2020 has seen the emergence of many solutions that propose to recreate financial products and services, without centralized organizations, without established trusted third parties. Among the most widely used use cases in Decentralized Finance, we find stablecoins, token exchange platforms (DEX), derivatives platforms, insurance products and loan and credit services.

Lending and borrowing services are one of the primary use cases for DeFi. These decentralized protocols connect borrowers and lenders (commonly called liquidity providers) of crypto-assets. Aave and Compound are the two most popular platforms in the credit market. They each have, in February 2023, a TVL (Total Value Locked) worth USD 4.73 and 1.89 billion respectively¹. To be able to borrow on these protocols, borrowers must first lock one (or more) crypto-asset(s) as collateral.

Loans are said to be over-collateralized because to be able to borrow the equivalent of 100 dollars, it is necessary to lock in the equivalent of 150 dollars, which guarantees repayment and cancels the risk of default. In the event of excessive market developments, the collateral is liquidated, i.e. sold in order to ensure the repayment of the loan. The lenders, on the other hand, receive interest, paid in the same crypto-asset as the one deposited.

Credit activity, the fundamental basis of finance

The consequence of the absence of a centralized organization, guarantee of the successful completion of a loan-borrowing transaction, therefore assumes that the loan is accompanied by collateral at least equivalent to the time borrowed. This condition, which allowed the emergence of the decentralized credit activity, is proving to be a strong limit for the development of this activity. Historically, banks were born from the need for financing of certain players in the economic world. Unable to meet this need with their own resources, companies turn to banks to benefit from one-off or more sustainable financing, depending on whether it is a cash or investment need. The banks will then ensure the relay of financing by granting a loan to the company and by being remunerated by a rate which reflects, among other things, the risk taken by the bank because of the uncertainty and the asymmetry of information. The interest rate is then the fundamental adjustment variable.

This rate, defined by the bank, is also important because it produces credible information on the nature of the borrower (Diamond, 1984, Fama, 1990) and participates in structuring the architecture and efficiency of the financial system as a whole (Boot and Thakor, 1997). Decentralized credit accompanied by significant collateral, or even a higher amount of collateral than that of the sum borrowed, does not allow the emergence of an interest rate that produces information on the health of the borrower.

In fact, the loan rate reflects more the constraint linked to the liquidity of the collateral than to the risk of the borrower. Indeed, the interest rate is determined algorithmically. Higher demand to borrow a crypto-asset pushes interest rates up and vice versa.

A solution can come, like what is practiced in centralized finance, from the absence of collateral or at least from a significant reduction in this collateral requirement. The latter then becomes a variable for adjusting the rate in the face of the asymmetry of lender-borrower information, without eliminating the role of a signal on the quality of the borrower.

It remains to be determined how to set this borrowing rate without sacrificing the decentralization constraint. Indeed, a simple solution would have been to call on a trusted third-party to assess the borrower's default risk and the real value of the collateral, if any, in order to then be able to define the borrowing rate.

However, this implies renouncing the decentralized aspects. One solution is to allow liquidity providers and therefore the market to determine the rate at which they are ready to lend via a decentralized auction process. The borrowing rate is then the result of this auction mechanism and is representative of the credit assessment made by the market. The rate then becomes again, as in centralized finance, an indicator of the counterparty risk of the borrower without sacrificing the decentralized nature of the protocol.

An important issue in the development of the decentralized lending/borrowing activity therefore lies in the production of reliable and interpretable information for lenders. In a centralized framework, the bank provides information obtained from a set of methods, often developed internally. In a centralized framework, the bank provides information obtained from a set of methods, often developed internally. In the case of non-bank debts of a significant amount, the rating agencies produce a rating which will inform potential lenders about the quality of the issuer. In both cases, the lenders-investors-depositors trust the rating work and lend at the rate set by the centralized organization.

The particularity of decentralized lending/borrowing today is the absence of a centralized agency for the production of information on borrowers. Each lender must therefore establish their own opinion on the basis of information provided by the protocol or that they will have sought. They can then define the rate at which they want to lend.

Since decentralization presupposes the absence of an intermediary that produces trust and information, decentralized protocols therefore have a crucial role in producing clear and quality information that will allow investors to benefit from the advantages of decentralized finance without suffering too much informational uncertainty.