by David Menzie
At Blockfolio, we strive to give you an objective picture of your cryptocurrency holdings and useful, relevant news. With that said, some of the products and services mentioned here are from ourselves or our partners. However, this doesn’t influence our evaluations. Our analysis is entirely our own.
1. Centralized Lending
Most of us are probably familiar with the traditional ("centralized") lending process, but let’s still recap through an example before discussing decentralized lending. Imagine you are an independent cryptocurrency miner interested in enhancing your hash rate to better compete with organized cryptocurrency mining pools - large group of miners who share resources and earnings. You find the perfect high-power GPU for the job, but it costs $10,000. Since you may be unwilling or unable to pay $10,000 up-front for that kind of hash power, but since you also want to strategically boost your hash rate during a crypto bear market, you decide to finance - borrow now and pay someone else back later - the GPU. Since you have a great track record of paying your bills on time and in full, you have built an impressive FICO - the most widely accepted US credit score - of 800. With this score and other personal information (income, employment status, accounts held, etc.) in hand, you apply for a loan from your community bank to cover the $10,000 GPU purchase.
Using this information, the bank underwrites - verifies your stated claims and determines a credit-based interest rate for - your requested loan amount. Since the bank deems you a good credit risk - likely to repay the $10,000 on time and in full - .it offers you a loan of $10,000 over 5 years at 5% interest for the GPU. Next, from the bank’s reserves - deposits from other customers - the bank disburses - transfers funds to the seller - the $10,000. After the seller is paid off, the bank then probably services - collects principal and interest payments for - your loan over the next 5 years. If everything goes according to plan, the GPU seller gets $10,000, you get your GPU, and the bank earns 5% in annual interest each year for advancing you the funds. However, if another crypto mining pool forms and reduces your relative computing power unexpectedly and you can no longer afford the payments on the GPU as a result, you may default - not fully pay back - on your loan. Regardless of the circumstance, a default will severely damage your credit score and cost the bank any remaining principal and interest.
As an important side note, if underwriting standards match market and risk conditions and careful due-diligence - evaluating a financial asset before purchase - is conducted, the centralized lending model can create value for all involved parties. If, however, underwriting standards are excessively lax and due-diligence is superficial, which was the case in the lead up to the 2008 global financial crisis, value can be quickly (and often unrecoverably) destroyed.
2. Decentralized Lending
Under a decentralized lending system, there is no central organization or institution, such as a bank, to supply the funds and underwrite the loan applications. Instead, investors - suppliers of credit - and borrowers - seekers of credit co-participate in an online “platform” or “marketplace” for credit. In the purest form of a decentralized lending system, prospective borrowers anonymously broadcast (“post”) their desired loan amounts, terms, and credit scores to a public ledger. Using this ledger, prospective creditors examine the profiles and statements of prospective borrowers, then determine which borrower(s) to fund - either in part or in full - depending on the creditors’ own capital stock, risk profile, and other non-financial factors.
a. Decentralized Lending Example
For an example, suppose again you’re an independent cryptocurrency miner looking to purchase a $10,000 GPU to mine cryptocurrency. However, since you are only 18, you have never legally borrowed before so do not have a FICO score. After you apply anyway and get rejected from numerous traditional banks due to your nonexistent credit history, you instead decide to “source” - gather in small amounts - the $10,000 through a decentralized lending platform. You join a P2P (Peer-to-Peer) start-up lending platform and post:
“18 year old US-based crypto miner with no credit history, looking for $10,000 to buy GPU for mining. Hardware will earn me $1000/month. I also have a part-time job at the local Dairy Queen making $15/hour and rich parents.”
Over time, as prospective investors evaluate your public plea and offer to contribute to your credit situation, you eventually earn the full $10,000 from 10 investors at an average interest rate of 12%. Since each of the 10 investors contributed a different amount, they are algorithmically tranched - categorized and ranked according to risk preference - by the platform. Because you are an uncertain high risk/high reward investment, the investors who elect to be paid back first will earn a low interest rate, below 12% (senior tranche), while the investors who elect to be paid last will earn a high interest rate, above 12% (junior tranche). If all goes according to plan, you pay your 5 year $10,000 loan back with 12% annual interest and each of the 10 investors receive an average of 12% return on investment from you. However, if you get fired from Dairy Queen and emancipate yourself from your rich parents so can only repay half of your loan, the senior tranche investors would get paid back while the junior tranche investors would get nothing.
Because of the under-compensated exposure to uncertainty and the inherent difficulty in anonymously coordinating capital inflows and outflows, most pure decentralized lending platform attempts have collapsed into insolvency - inability to pay debts. Platforms that have survived, such as US-based Lending Club, have done so by repositioning themselves as automated personal loan underwriting services, relying heavily on traditional FDIC-insured banks and mature capital markets to supply funding and manage platform liquidity and solvency risks. In general, since the release of Bitcoin and blockchain in 2009, blockchain-inspired decentralization has been proven exceptionally effective for ledger, record-keeping, and transaction-based use-cases, but, at least through 2019, has not advanced traditional credit risk evaluation or decentralized lending in any meaningful way.
3. Cryptocurrency Lending Model
Now that we’ve covered centralized and decentralized lending, we can now discuss crypto lending. As of 2019, the still amorphous cryptocurrency lending system incorporates aspects of centralized lending, decentralized lending, and exchanges, but the Bitcoin-esque game-changing solution has proven highly elusive. Since the release of Bitcoin, there have been multiple attempts made by talented teams of coders around the world to develop viable cryptocurrency lending solutions. Each time, however, the regulatory risks and complex supply-side challenges have stymied, then eventually overwhelmed, the project. In theory at least, the crypto lending system begins by a coordinated team of developers building a platform to supply prospective cryptocurrency borrowers with credit. Once the platform launches, prospective cryptocurrency borrowers join and place requests into the platform (“inquiries”) to borrow against their cryptocurrency. With the request, the platform algorithmically screens the borrower for identity, creditworthiness, and quality of pledged collateral, then offers up a portfolio of micro-loan profiles for the borrower to select from. Once the crypto-borrower selects his/her preferred loan profile - term, interest rate, and amount - a smart contract is automatically initiated, the pledged collateral is deposited, and the borrower enters into repayment. Once the loan reaches maturity - the term duration has elapsed - the borrower is returned his/her token collateral at the prevailing market token price and the contract is terminated and discarded.
a. Cryptocurrency Lending Model Example
Since even describing this process is complicated, let’s as usual illustrate with an example. Suppose you own 2 Bitcoins and you’re looking to borrow a small amount of money to develop and market your own token. You open your Blockfolio app, and see BTC is tracking at $8,000 as of June 2019, so your two Bitcoins are worth $16,000. Although you only need $4,000 to launch your token, you decide you’d still like to finance - borrow now and pay someone else back later - your token endeavor. Since the community bank doesn’t (yet) accept Bitcoin as collateral - the portion of the loan you deposit up front to receive back later - you search for alternatives. Of course, you could always sell your two Bitcoins for cash through an exchange, but you believe that the price of Bitcoin will rise, so would rather not sell your 2 Bitcoins. Instead, you discover a Bitcoin-supported cryptocurrency lending platform, which will enable you borrow against your Bitcoin without selling your Bitcoin.
Excited by the prospects, you join the platform by entering and scanning your personal information into a digital form and are quickly approved by the platform’s Know Your Customer (KYC) identity algorithm. Using neural networks, AI, rich data banks, and your provided information, the platform issues you a “digital credit score” - a scaled likelihood of loan repayment. With your great digital score and “Authorized” KYC status, you then initiate a loan contract by pledging your 2 BTC as collateral, requesting 2.5 BTC ($20,000 / $8,000) in return. Using your great digital credit score and BTC as an input, the platform “grades” the BTC collateral as “High”, then offers you a choice between a 3% interest rate for 3 months or a 5% interest rate for 6 months for the 0.5 additional BTC. You pick the 3% interest rate option, triggering the creation of a 3 month smart contract - an automatically executing and enforcing legal contract. The platform then deposits 0.5 BTC - $4,000 - into your account, then absorbs your pledged 2 BTC as collateral. Over the next 3 months, you make the weekly loan payments and watch on Blockfolio as the price of BTC rises by 50%! After you’ve made your final scheduled payment, your 2 BTCs are automatically returned to you. Because the market price BTC has appreciated by more than your interest rate, you’ve successfully completed a full borrow-and-earn cycle.
As an important side note, if the price of BTC had instead fallen by 50% over the same period, you may have been required by the platform to make periodic margin calls - additional contributions to your collateral - to preserve its absolute value. In this “bear” market case, not only would you have lost 50% on your original BTC, but also 3% in interest and up to 50% on each margin call. Therefore, borrowing against crypto in this way will ALWAYS magnify your crypto exposure, so please be careful!