Decentralized Finance (DeFi) and cryptocurrencies have the potential to revolutionize personal finance by allowing individuals to borrow and lend money without using traditional financial institutions such as banks. While this may be a great opportunity, there are always risks involved with making loans, and one of people's greatest fears is that they will loose their money if the borrower does not pay back the loan. In the traditional financial world, the possibility that a borrower will fail to repay the loan is known as default risk. The possibility of losing money is a serious concern, and the purpose of this article is to demonstrate how decentralized financial platforms use loan over-collateralization to mitigate the default risk inherent in traditional loans. This is not an evaluation of any specific DeFi platform, but rather a general analysis of how over-collateralization of loans can protect lenders from default risk within the cryptospace.

Traditional Loan Risks

To understand how over-collateralization helps reduce the risk of default, we first need to understand how a traditional loan works. Let's suppose that you wish to take out a loan to buy some new property or start a business. The bank will try to gather information to determine how likely you are to pay that money back. They may research things such as your character, how stable your employment is, whether or not you have defaulted on debts in the past, and whether you have enough income to be able to repay the loan (Yardney, 2018). Depending on these various factors, the bank determines how likely you are to default on the loan. After the bank has evaluated your situation, it will determine whether or not it will issue you a loan and what the interest rate will be.

Just for this article, imagine that the bank determined that you had a perfect credit history, a high paying job, and had a perfect credit history. In this circumstance, they may give you a loan is simply based on your character, capacity to repay, and credit history. This is called an unsecured loan because there is no asset backing the loan. The bank is simply giving you the money because it believes you will repay it with interest.

In the real world, however, this is highly unlikely. Even after conducting all this research into your history and your ability to repay the loan, many banks still require that you put forward some form of collateral. To use the most simple terms possible, collateral is something that the borrower agrees to give the lender if they can't repay the loan. The collateral in a loan is a way to protect the lender from default risk. For example, if I want a loan for a new house, I could pledge the house as collateral. This means that if I do not make the payments on my house loan, the bank has the right to sell the house to get their money back. Collateral can be anything from cars, homes, businesses, or even cryptos as we will soon see. I want to point out that collateral is only taken if the borrower fails to pay the loan. Collateral is only there to secure the loan and ensure that the bank (and the people who deposit money in the bank) has some way to recover its loan if the borrower does not pay.

Crypto Loans and Default Risk

However, this system of checking credit history, job stability, and the ability to repay doesn't work that well within the privacy-focused nature of decentralized lending platforms for cryptocurrencies. Most importantly, cryptocurrencies are pseudonymous. This doesn't mean that they are completely 100% private or untraceable, but it does mean that there is no reputation or personal reputation or identity attached to each borrower (Chong, 2019). Because of the pseudonymous nature of cryptos, traditional methods of assessing default risk can be replaced with loan over-collateralization to protect lenders.

So then, how do decentralized lending platforms solve this default risk and ensure that lenders don't lose their money? Because decentralized lending protocols are not able to investigate potential borrowers, they rely much more heavily on collateralization to secure the loans and ensure that lenders don't lose their money. In fact, many authors have used the term over-collateralization to describe crypto lending because potential borrowers must put in more collateral than the value of the loan that they are taking out.

Collateralizeation Factor

One way that DeFi platforms can secure loans even if they know nothing about the borrower is by using a collateralization factor. A collateralization factor determines the absolute maximum amount of an outstanding loan that can be generated given a certain volume of collateral that has been deposited. For example, a collateral factor of 75% means that if someone deposited $100 worth of crypto, they could take out $75 worth of crypto. If the collateral factor was 50%, the borrower could take out $50. Please take note that the collateralization factor represents the absolute maximum loan that can be taken out for a given amount of collateral, and it is wise for borrowers to take out less than the maximum amount to account for changes in the value of their collateral as well as the accrual of interest.

If the outstanding balance on a loan exceeds the collateralization factor, the collateral is sold to pay back the loan. Because of the way an over-collateralized loan is structured, lenders will still get their money back even if the borrower defaults. Because the value of the collateral must exceed the value of the loan, the DeFi platform will simply sell the collateral to ensure lenders get their funds back. Not only do lenders want to get their money back, they also want to earn interest on their loans. Crypto lending platforms sometimes call the interest rate a "stability fee" which is more or less the same as a traditional "interest rate." Over-collateralization ensures that even in the event of a defaulted loan, lenders will still receive their funds and interest.

Example of Loan Liquidation

Consider this example that is not meant to describe any specific DeFi platform. Suppose that I put $10 worth of ETH into a platform as collateral with a 50% collateral factor. This would mean that the maximum I can borrow is $5, but let's suppose I only take out $4 of a stable coin such as DAI. If the stability fee is 20%, then I will be charged $.80 worth of interest in one year. At the end of year 1, the balance of my outstanding loan will be $4.80. Since the $4.80 is still less than the $5 determined by my collateralization factor, I am still below my max borrowing limit. My loan will not be liquidated at that time.

By the end of the second year, my outstanding loan will be $5.76, and I will have exceeded the amount allowed by my collateralization factor. Keep in mind that interest and stability fees are calculated in real-time with decentralized finance, and I would exceed my borrowing limit sometime before the end of the second year. The liquidation process would begin as soon as I exceeded my collateralization factor, whether or not it had been a full year. Loans can also be liquidated if the value of the underlying collateral decreases. Suppose that I had the same $10 deposit of ETH with a 4 DAI loan but that the price of ETH fell to $5. In this case, the value of the $4 DAI loan would exceed the allowed 50% collateralization factor and my loan would be liquidated just the same as if ETH remained stable, but I allowed to much interest to accrue and did not pay the stability fee. Over-collateralization protects lenders in both situations.

If a borrower sees that they're getting close to approaching the limit of their collateralization factor, they can either deposit more collateral or they can repay some of the existing loan. However, let's suppose that the borrower simply cannot deposit any more collateral or repay the loan. In this situation, the platform begins to liquidate the loan. If the value of the outstanding loan exceeds the allowable limit set by the collateralization factor, the loan will be liquidated and some of the collateral will be sold to pay back the loan and interest. After the loan and interest fee is paid back, the borrower will receive whatever remains of their collateral (Maker, 2019). Because the value of the collateral is always more than the value of the loan, the system can automatically sell-off collateral to repay the loan and the interest. This ensures that lenders get their money back, but it also protects borrowers from falling into a black hole of debt. The most they can loose is the value of their collateral.

This Makes No Sense?!

At this point, you may be wondering why someone would deposit $30 worth of collateral to take out a $20 loan. Wouldn't it just be easier to sell $20 worth of the ETH or Bitcoin and buy whatever you needed for $20? One of the reasons is because taking out an over collateralized loan allows the borrower to retain ownership of their collateral. To use a more familiar example, let's suppose that you want to buy a new car. You could sell your house and use the money from the sale to pay for the car, but then you wouldn't have a house. On the other hand, you could pledge your house as collateral that you would pay off your car loan, and once the car loan is paid off, you still have both the house and the car.

Over collateralization of crypto lending has the same effect. Loan over-collateralization and decentralized finance allow people to use their cryptocurrencies like Bitcoin to achieve short term liquidity while retaining long-term ownership of their assets. Let's suppose that you own some Bitcoin and believe that the price will double or triple in the next few years. At the same time, you need a small loan for car repairs. If you sell your Bitcoin today for $8,500 to pay for this car repair you won't be able to sell if for a hypothetical $20K in a few years. Instead, of missing out on this potential, you can pledge your bitcoin as collateral and use the loan to pay for the repairs. Once you pay back the loan, the Bitcoin would still be yours, and you could sell it for 2X or 3X the price that it is today.

Conclusion

This article is in no way intended to imply that cryptocurrency lending is completely risk-free. Default risk is only one of many risks involved in lending. There are inherent risks with lending on decentralized platforms including contract security risks, centralized points of failure, and bank run risk (Soleimani, 2019). Although crypto lending platforms can't solve every potential risk, they have made considerable progress in reducing the default risk by implementing over-collateralized loans which protect from losing their funds if a borrower defaults.

As always, any risks involved in lending should be evaluated carefully and you should do your own research (DYOR) to determine what investments best suit your needs and if you want to invest at all. For an excellent overview of the loan process specific to MakerDAO, I recommend reading " What is the MakerDAO CDP " by Winter (2019).

References

Chong, K.T. (2019, July 3). Ultimate Guide to Ethereum Lending: ETHLend, MakerDAO, BlockFi, SALT, Dharma & Compound. Retrieved October 24, 2019, from https://blokt.com/guides/ethereum-guides/ethereum-lending.

Maker. (2019). The Dai Stablecoin System. Retrieved from https://makerdao.com/en/whitepaper/#debt-and-collateral-auctions-multi-collateral-dai.

Soleimani, A. (2019, September 4). What You Should Know Before Putting Half a Million DAI in Compound. Retrieved October 24, 2019, from https://medium.com/@ameensol/what-you-should-know-before-putting-half-a-million-dai-in-compound-fafdb2645f77.

Winter, E. (2019, June 10). What is the MakerDAO CDP? Retrieved from https://www.publish0x.com/dai-fans/what-makerdao-cdp-xomoov

Yardney Michael, M. (2018, January 17). How banks assess your property investment loan application. Retrieved October 24, 2019, from https://propertyupdate.com.au/how-do-the-banks-assess-your-application-part-1/.

Image Credits: David McBee



