Want Real Mass-Adoption? We Need to Get Undercollateralized Loans Right

TL;DR: This blog post discusses the potential for undercollateralized
loans in the world of decentralized finance (DeFi) and how the Dusk
protocol is working to make them a reality. It explains the difference
between collateralized and undercollateralized loans and why the latter
are important. It also discusses the recent failure of Orthogonal
Trading and suggests undercollateralized loans could prevent such
situations in the future. It concludes by suggesting that
undercollateralized loans could be a major step forward for RegDeFi.

As DeFi grows in maturity, we see more and more tools, services, and
products to meet the permissionless, trustless, and on-chain needs of
the DeFi community. We have seen the rise of AMMs, stablecoins, and
collateralized loans to name a few, each of which further develops the
DeFi ecosystem and finds a way to bring a traditional financial service
on-chain.

As you can imagine, there are challenges. But, nevertheless, DeFi
continues to grow, learn, and evolve.

One of the latest innovations to be challenged in the world of DeFi is
undercollateralized lending. A key feature of RegFi, DeFi is still in
the early stages of working out how to run, deliver and maintain a
viable undercollateralized lending market.

In the last few days, it has come to light that Orthogonal Trading had
an undercollateralized loan from a pool managed by M11 which was issued
via Maple Finance’s tooling. Maple Finance and M11 have announced that
Orthogonal misrepresented their financial situation following the FTX
collapse and had a liquidity issue - hence requesting the loan, and
Orthogonal has recently declared insolvency. Another one bites the dust.

While this situation is incredibly sad for all will take a hit,
undercollateralized loans are something DeFi needs to get right if we
are to grow and become a realistic option for on and off-chain finance.
It’s important to remember that while DeFi may need to develop
equivalent services to Web2, we can’t just copy-paste what RegFi is
doing. The ecosystems are different, the tech is different, and the way
of doing business is different, so while these products are useful we
can’t necessarily just blindly replicate them on DeFi with the same
format. When that happens, it typically doesn’t work so well due to the
differences between the industries.

So, in this post, let’s look at why undercollateralized loans are
needed, the role they serve, and why Dusk is one of the only - if not_
the_ only - protocols that can pull this off.

What is an undercollateralized loan and why does DeFi need them?

Collateralized loans

Before getting into what undercollateralized loans are, let’s first
explain their “opposite”, a collateralized or in some cases
over-collateralized loan.

Overcollateralized loans have been incredibly popular in DeFi. With this
type of loan, you put up your crypto collateral and can borrow against
it. You might deposit $10k worth of $ETH, and borrow $9k worth of
stablecoins against it.

When you repay your loan you get your $ETH back, and if you are unable
to repay it or if the value of your collateral falls below a certain
threshold compared to what you have borrowed, your collateral is
liquidated to pay back the loan.

This has helped projects and blockchains attract and keep liquidity, and
has been a key feature in the development of DeFi.

One of the advantages of offering loans on-chain is that the position
and liquidations are done on-chain by smart contracts. You can’t reason
with a smart contract, so if your position’s health falls below 1, you
get liquidated. It’s worth noting that Alameda paid back their on-chain
loans first due to the efficiency and straightforwardness of smart
contracts. There’s no “Please, just give me a bit more time”.

The efficiency and swiftness, not to mention the transparency, of smart
contracts, are important points, and ones we’ll return to later.

What are undercollateralized loans?

Undercollateralized loans are ones in which you do not put up the full
amount of the loan as collateral before borrowing funds. While this
sounds a bit crazy, the economy is built on this type of lending! A key
example would be the mortgage industry;

If I want to buy a house, but I don’t have the liquidity to pay for it
all upfront, I ask a bank for a loan - aka a mortgage. The bank checks
out my credit history and income and decides to give me the loan.
Typically the bank would require me to put up a percentage of the total
amount as a deposit, before lending me the rest.

If I fail to repay the loan, the bank would seize the house and sell it
to recoup the money they lent. Depending on the state of the housing
market, they might lose, make money, or break even on that sale. In
practice, they’re taking a calculated risk on the loan.

Undercollateralized loans are a key ingredient of economic growth. By
allowing individuals to secure financing for homeownership or
entrepreneurship, these loans enable them to invest in assets that are
expected to appreciate in value. Additionally, the use of borrowed funds
in multiple ways at once allows money to work harder, spurring economic
growth.

One of the issues facing crypto and DeFi at the moment is that it’s not
easy to create value. We can convert fiat into crypto tokens, we can
move assets around swapping between them, but it’s all very contained
within the DeFi sandbox.

Like rearranging your furniture. There might be better ways to structure
and position your furniture, but you haven’t actually created more space
in your living room, you’ve just moved the furniture around.

So, in order to provide a real alternative to RegFi, DeFi needs to
develop its undercollateralized loan mechanisms, as without it we’re
just moving the furniture/assets around and relying on new money coming
on-chain from fiat into crypto assets.

What went wrong with Orthogonal Trading?

Orthogonal Trading were insolvent but were able to misrepresent their
financials and take out loans they couldn’t repay.

In RegFi there is a huge amount of infrastructure supporting
undercollateralized loans, from banks to regulators to checking your
credit history, and they still get it wrong sometimes (cough cough,
Global Financial Crisis).

In this case, Orthogonal Tradings’ “misrepresenting their financial
position” has led to a bad situation where the lending pool managed by
M11 is impacted by an irredeemable debt. This mimics the equivalent
RegFi’s situation, where the burden of recourse is on the lender.

In other words, in RegFi, if I lend you money and you can’t repay your
debt, that’s my problem! I can appeal to various authorities and try to
get back what I lent you, but ultimately I may never recover my money.

There are two externalities lenders must consider when making decisions
about lending money:

1. The depreciation of the asset at stake (e.g. a house)

2.  A misvaluation or misrepresentation of the asset (e.g. the house is
   valued at $1 million but it turns out it’s built on a garbage dump
   and is worth way less)

Due to the risk being on lenders, those are understandably conservative
about who they lend money to. This can make it hard for people or
businesses to access financing opportunities and obtain the liquidity
they need, while those who can prove a successful credit history have
easy and often cheap access to liquidity.

Overcollateralized, on-chain loans reverse this. Borrowers must post
their collateral in advance, and if they are unable to pay back the loan
or the value of their collateral falls below the value of what they
borrowed, they are automatically liquidated. So here the risk is on the
borrower, and the smart contract will execute automatically.

What if we could have the best of worlds?

The growth-facilitating effects of RegFi undercollateralized loans, with
the efficiency and clarity of smart contracts that we’ve seen with
overcollateralized loans?

Dusk’s Solution

Dusk is on a mission to make finance better by bringing Reg to DeFi. One
of the ways we can do this is by offering economy-boosting
undercollateralized loans, on-chain, in a way that is efficient and
opens up the crypto sandbox.

How does Dusk provide the best of both worlds?

Dusk is a Layer-1 blockchain that has regulatory compliance built in.
This gives us the birth of Regulated DeFi.

This opens up the crypto sandbox to the traditional world of finance,
while giving traditional financial institutions access to the amazing
technology that is blockchain. Securities, bonds, and other financial
products can be tokenized and brought on-chain.

One of the challenges that RegFi faces is a lack of homogeneity between
assets; a house is not the same as a security which is not the same as
fiat, for example.

But, as far as the blockchain is concerned, they are just byte-encoded
data. By allowing traditional assets to be tokenized, we open up a lot
of opportunities. As long as we can put a value on an asset, it can be
integrated on-chain and have the same congruency as all the other
assets.

What does this mean?

It means we can have the capital efficiency of undercollateralized loans
with the technological efficiency of the blockchain.

RegDeFi - when applied to the lending/borrowing market - removes
multiple issues. It removes the externalities that lenders face. It
decreases the risk for the lenders by placing the burden of asset
recourse on the borrowers if the latter does not pay the loan back. It
reduces (or even removes entirely) the ability for companies to lie and
misrepresent their position. But best of all, it removes the need for a
centralized entity.

If you take a loan to buy a house, the house can be tokenized, opening
up the possibility of on-chain loans for (previously) off-chain assets.
Your new house is now on-chain and linked to your digital identity.
Real-world goods and traditional securities are also nominal
(i.e. linked to your identity rather than a wallet) and can be traded
on-chain. Lenders are able to repossess assets (like a bank would if you
default on your mortgage) linked to the borrower’s identities, and as
such DeFi can progress beyond the world of crypto and become RegDeFi.

How will undercollateralized loans change DeFi?

Whether you’re a crypto investor hungry for mass adoption and to
actually be able to put your crypto to work, or a financial institution
watching and waiting for blockchain to be able to get you on-chain and
improve the way you do business, there’s a lot to be excited about!

Undercollateralized loans have been the building block of the economy,
allowing people, businesses, and industries to grow based on the promise
of future return, and, with Dusk’s tech and compliance, we can bring it
on-chain.

As excited as we are about the tech we’re building, we’re excited to see
how you will use it.

Will you be able to buy a house using $ETH as the deposit?

How many businesses will be built thanks to loans provided through
RegDeFi?

How much more efficient and transparent will traditional institutions
become?

How will borrowers behave differently if their loan is managed by a
smart contract - programmed to execute when given conditions are met -
and not people who can be lied to and manipulated?