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?
About Dusk Network
Dusk Network is the privacy blockchain for financial applications. A new standard for compliance, control, and collaboration. Our mission is to enable enterprises of any size to collaborate at scale, meet compliance requirements and ensure that personal and transaction data remains confidential.