This blog post serves the purpose of being a short introduction to the content of the actual paper. The actual paper (in PDF format) can be found in the 3six9 Innovatio Documentation.
Purpose of This Paper
Money markets play a crucial role within a financial system and show strength and traction in both the TradFi and the DeFi space. In the current DeFi environment, the overcollateralized character of present lending markets limits its use cases and capital efficiency. Due to the pseudonymous nature of blockchains and wallets, offering un(der)collateralized loans is hard to nearly impossible at the current state. As of writing, a handful of projects are actively working on solving this matter with likely a lot more projects/teams flying under the radar.
This paper analyzes sixteen protocols that are-tackling the issue of un(der)collateralized lending in DeFi. The main goal is to outline the current market situation, but also to create a framework for undercollateralized loans by aggregating the benefits and pitfalls of current solutions developed by existing protocols. We hope that this paper can act as a source of information for those interested in this lending niche or in developing a new solution.
As developers started experimenting with blockchain technology and its potential, the financial sector presented the need to build blockchain-based fintech applications. Secure distributed ledger technologies have eliminated the need for third parties in financial transactions creating an open and permissionless form of finance dubbed ‘Decentralized Finance’ (DeFi). This crypto sector features financial products such as trading platforms, decentralized exchanges, insurance services and money markets.
One of the thriving subcategories within DeFi is money markets. In the current state, money markets give users the ability to deposit collateral and borrow digital assets in a trustless manner. Lenders are able to earn interest, whereas borrowers are able to leverage up or be more capital efficient with their portfolios. The benefits of decentralized money markets include a censorship-free process, transparency, improved loan origination speed, and permissionless. Additionally, as the crypto industry has grown to a size of trillions, the presence of credit markets is important to stimulate economic growth and improve the use of digital assets on blockchains.
While transparency, over-collateralization and automation make DeFi dramatically less exposed to systemic risks, but inevitably make the credit market less capital efficient. This design choice was taken given the inherent lack of trust in anonymous transactions and the high volatility of the assets used as collateral. In order to protect lenders, the borrowers are mandated to post collateral that is automatically liquidated when their loan-to-value (LTV) ratio falls below a certain threshold.
The absence of know-your-client (KYC) and anti-money laundering (AML) information makes it hard for existing protocols to offer more effective solutions. Over-collateralization in DeFi limits capital efficiency and hinders future (exponential) growth of crypto-native money markets.
Rudimentary forms of unsecured lending have been developed in recent times but often involve entities established in Traditional Finance (TradFi) / Centralized Finance (CeFi) accompanied by some form of borrower creditworthiness analysis. This type of lending could improve a lot of the bottlenecks in the current DeFi lending landscape and the overall capital efficiency in the space. Some of the on-chain unsecured lending solutions currently on the market and presented in this paper require the borrowers and/or the lenders to go through identification processes. This compromises the whole crypto ethos of censorship resistance and decentralization.
This paper aims to be a framework for the proper implementation of unsecured loans in DeFi. We believe that by analyzing the current market, we are able to identify key factors that others can use to develop a well-functioning lending service.
3six9 Cognitio is very dedicated to its research philosophy. We really hope that you will join us on this journey.
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🗡 ABOUT 3six9 Cognitio
3six9 Cognitio is the 3six9 Innovatio research and education wing which is currently researching on a variety of topics such as undercollateralized loans, zkKYC, optimized stablecoin designs and much more.
Our team of researchers and content writers work in tandem with 3six9 Core Team. The goal is to have an in-house team to cover all of 3six9 needs with regards to content, impactful research and analysis that we can leverage when building out our products, as well as pushing interesting research papers for our community.
Our goal with 3six9 Cognitio is to also build out a central hub for all things crypto. We aim to build a place where it's easy to learn about the complex crypto space in a digestible way. Onboarding and welcoming new users to the space is important to us. As well as keeping our community up to date with the latest Open Finance related trends and providing you with alpha.
If you would like to contribute to our research endeavors, reach out through any of the following channels:
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