Lending and borrowing on the blockchain — should banks be scared?

Blockchain is often associated with the future of finance, but in the case of lending, could it actually take us back in time?

Before the rise of banks, loans and repayments took place peer-to-peer. People had to trust each other. Over time (perhaps inherent to human nature?) trust began to break down, and intermediaries and third parties were added to the equation. These middlemen provide a layer of protection, but in doing so charge high fees, while adding extra layers of complexity and regulation to the process of lending and borrowing.

Enter blockchain.

Built on a distributed ledger, the very nature of its design is trustless and decentralized. This makes it possible to transfer ownership of an asset from one person to another, without the need for an intermediary, an attribute which could help revive peer-to-peer lending practices and even propel it to new heights of popularity.

The benefits, particularly for individuals and small-to-medium-enterprises (SMEs) are significant, as access to credit can often be difficult, with many hoops to jump through.

If there is an option to get a loan without going cap-in-hand to the bank, people will take it. The rapid rise of crowdfunding and ICOs, for example, demonstrates a willingness to embrace alternatives for raising money.

Blockchain lending essentially builds on the timeless peer-to-peer model, making the entire process more seamless and reducing the amount of time the process takes. The middleman (a bank) is cast aside, and individual borrowers or businesses are connected directly to willing lenders. The great value of such decentralized lending is that with a single request, a borrower can access very competitive financing, as geography being no constraint on a blockchain platform, lenders from all over the world can bid to provide the loan.

Thanks to smart contracts, lenders are able to validate transactions, verify the legitimacy of counterparties, and perform routine account administration tasks almost momentarily, reducing costs and accelerating the process.

Importantly, there is no need to rely on a third party for background checks or “proprietary ratings”. Since all transactions are open and auditable, every address can be assigned a credit rating, almost trivially. The transactions of a given address can be be analysed in detail. For an example of how powerful a tool this can be, just go to Ethstats and enter an Ethereum address, to see incomings and outgoings. If there is any suspicious or unusual activity that raises the eyebrow of the loan provider, then they can simply refuse to extend their services.

Banks will not be willing to stand by and let peer-to-peer lenders take too much of their delicious pie.

The innovation units within many major banks do not feel threatened by the technology, but are rather keen to embrace it and incorporate it into their systems. For example, ING and Credit Suisse are already swapping high quality liquid assets using a blockchain-based collateral lending application.

The benefits for banks of utilising blockchain tech are much the same as for individual loan providers, but perhaps even more useful for larger institutions, as they can streamline and optimise their operations. Blockchain naturally connects all parties on a system, so the customer would be linked directly to the lending institution, with full transparency and a real-time view of finances on an immutable ledger. This means there is much less need for due diligence which is very time consuming and expensive — a cost which is often pushed on to the borrower.

If a bank had a full transaction history, with inflows and outflows, details of outstanding bills, and so on, then a lending decision becomes much easier. It could run a credit worthiness check algorithmically, speeding up the process significantly. Codified instructions generated by smart contracts can be extremely useful for reducing errors, fraud, automating the settlement process and digitizing contracts. Efficiency would be improved, as managing the lending workflow is tedious and time consuming, but can be largely automated on the blockchain. Not to mention that blockchain also allows safe permissioning of data visibility for auditors, regulators and investors, and secure transmission and storage of sensitive data.

So it all sounds great so far, but don’t lose sight of the fact that this lending model is in its infancy.

There are various hurdles to widespread adoption, especially in relation to know-your-customer (KYC) rules, establishing and verifying identities, onboarding new customers and determining creditworthiness.

A real challenge is presented in collecting loans made on a blockchain — it will certainly test the legality of smart contracts, and would require a global regulatory framework for true peer-to-peer lending across borders. Just because it is legal one country, does not make so in the next. Currently, it is very difficult to get courts to recognise smart contracts as a valid way to do business.

So while a distributed ledger records that a transaction has taken place, the evaluation and management of risk, as well as enforcement, is still a grey area. At this stage, blockchain is still relatively young and doesn’t have many user-friendly tools required for complex operations. On the other hand, that doesn’t stop determined entrepreneurs from setting out to fix this, and some of projects detailed below have the potential to evolve into or inspire the lending giants of the future…

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SALT — a platform that allows cryptocurrency traders to use their crypto assets as collateral for loans.

SALT is currently the biggest player in blockchain lending, sitting on a marketcap of $17 million and around 65,390 holders.

Members of the SALT (Secure Automated Lending Technology) platform can borrow money from an extensive network of lenders, who determine the eligibility of a borrower based on their blockchain assets. Approval is fast, although still subject to AML/KYC procedures, and collateral assets are kept in a “fully-audited, ultra-secure architecture”. Borrowers are charged interest on the loan, as they would be on any other loan. However, unlike other loans, when a borrower pays it off, they receive their blockchain assets back.

Lenders need a significant incentive to finance loans collateralized by blockchain assets. According to David Lechner, the chief financial officer at SALT, someone looking to tap $100,000 in cash would probably need to put up $200,000 of bitcoin as collateral, and pay 12 percent to 20 percent in interest a year.

If the value of the blockchain asset used as collateral changes (as it almost certainly will, over the course of a loan), there are decisions the borrower has to make.

Should the crypto collateral rise, the borrower can add the increased value of their collateral asset to the principal of the loan for additional capital from the lender, or they can do nothing, leave the loan as is, and receive this blockchain asset back, at its increased value when they pay off the loan.

If the crypto collateral plummets and causes a breach of the loan-to-value (LTV) threshold, SALT will contact the borrower, and give them the option to add collateral, or make an additional principal payment, to bring the collateral account balance back into balance.

It’s important to note that all of the lenders are Accredited Investors under Regulation D of 17 CFR § 230.501 et seq., who have passed the a Lending Suitability Test. The loans are not transferable via blockchain; they are themselves securities that are transferable through existing financial channels.

Those who borrow on SALT will be bullish on the long-term prospects of the cryptosphere. SALT could certainly prove popular, especially amongst bigger holders — whales and miners — who don’t necessarily want to liquidate their crypto assets as they believe they will continue to appreciate in value, but they still want to spend their crypto wealth (Lambo anyone…?)

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ETHLend — a decentralized financial marketplace built on top of the Ethereum Network allowing lenders and borrowers from all over the world to create peer-to-peer lending agreements.

ETHLend has a marketcap of $8.3 million and around 164,000 holders.

ETHLend adopts a more free-market approach as a facilitating platform, similar to many peer-to-peer fiat lending options. Borrowers and lenders can connect and negotiate everything from interest rate to duration. The platform is entirely based on Ethereum, but any ERC20 tokens are admissible as collateral on the loan. If borrowers fail to abide by the terms of the smart contract, then all collateral is forfeit.

ETHLend is truly global, allowing anyone in the world to borrow or lend, as long as they have an Ethereum address. No central authority can restrict access, and people in regions where financial access and services are very limited have a powerful tool at their disposal. Since there are no bank accounts involved, all one needs is an Ethereum wallet address in order to send or receive a loan. There are no variable interest rates, as ETHLend wants to keep fees as low as possible for all parties involved.

Trust, transparency and access are the big positives of ETHLend, but it is also working on some more advanced features, such as on-demand lending, crowd lending, and decentralized credit scoring. ETHLend plans to partner with Bloom, an end-to-end protocol for identity attestation, risk assessment and credit scoring. Thanks to Bloom, a borrower at ETHLend can use credit scores that the person has gained based on their on-chain and off-chain credit-related activities, while lenders can identify risk of default more easily.

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Ripio Credit Network — a peer-to-peer global credit network protocol based on cosigned smart contracts and blockchain technology.

Ripio Credit Network (RCN) has a marketcap of $5.2 million and around 8,000 holders.

Ripio’s platform went live in April 2018, and is primarily focussed on Latin America, where 63% of people are unbanked. Its a protocol based on smart contracts and blockchain technology, which seeks to bring enhanced transparency and reliability in credit and lending. The protocol enables connections between lenders and borrowers located anywhere in the world, regardless of currency. By reducing the traditional banking brokerage costs and management fees, RCN aims to allow better conditions for both sides.

RCN actually introduces an intermediary agent into the process of getting a loan. If you want to join the network as a lender, a “Cosigner” will act as a go-between for your borrower and the network. In theory, this means the lender’s credit risk is somewhat lessened. In case of a default, the Cosigner works as an alternative mechanism for managing debt collection in the borrower’s country of residence. However, this gives the Cosigner a great responsibility — if they are incapable of actually enforcing loans for any reason, the overall value of the network would begin to slip.

An interesting aspect of Ripio’s model is that they also report to credit agencies, whenever possible. This reverts back to legacy systems, and could well limit the amount of people eligible to participate in the system. However, they recently partnered with Bloom, so like ETHLend, might be leaning more on this solution for risk-assessment and credit scoring in the future.

Importantly, multiple local currencies will actually be traded in order to get RCN tokens and thus access the decentralized borrowing and lending network. Cryptocurrency ownership is not necessary, which should reduce the friction of entry for a lot of people unfamiliar with the cryptosphere. ___________________________________________________________

An interesting development is the rise of DeFi projects, which leverage Ethereum to provide crypto-backed loans.

Dharma is a platform for building globally-accessible lending products using programmable, tokenized debt. It can support virtually any kind of lending product you can imagine.

Here is a good article explaining the various components of the protocol in more detail: https://medium.com/@espitia7/dharma-protocol-an-overview-d761c39426ac

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Compound Finance is an open-source protocol for algorithmic, efficient Money Markets on the blockchain.

It’s possible to supplky and borrow assets using the platform, of which more info can be found here: https://medium.com/compound-finance/the-compound-guide-to-supplying-borrowing-crypto-assets-94821f2950a0

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Maker DAO enables anyone to leverage their Ethereum assets to generate Dai (a stablecoin). The value of DAI is backed and stabilizes the value through a dynamic system of Collateralized Debt Positions (CDPs), autonomous feedback mechanisms, and appropriately incentivized external actors.

It’s a complicated system, and beyond the scope of this overview to dive into the mechanics, but there is plenty of Analysis on Trivial’s profile page for Maker if you want to learn more.

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In Shakespeare’s play ‘Hamlet’, old Polonius counsels his son to “neither a borrower nor a lender be.” While a noble sentiment, it must be recognised that this is one of the biggest businesses out there. For blockchain to be taken seriously, this is exactly the sort of industry it needs to disrupt, and the models proposed by some of the projects above certainly have a chance of doing this.

While blockchain doesn’t really reduce credit risk, it could nonetheless dramatically reduce operational risks, improving the efficiency of funding and lending models through more decentralized, trusted, immutable records with better pricing and confidence in the underlying assets. I’m sure there will be more and more offerings for blockchain based lending coming out over the next years, and it will be very interesting to see how they develop and what sort of attention they attract from banks and regulators, especially if people begin to adopt such platforms more widely.

What do you think about blockchain based lending and borrowing? I’d love to discuss in the comments!

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You can get more details and track the projects mentioned above using Trivial’s token discovery platform — I recommend it as a launch pad for researching new projects!

Some of the cool things you can do with it: