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Undercollateralized Loans: The Future of DeFi?

In this article we discuss the latest service-offering from the DeFi world, undercollateralized loans, and how it is touted as the future of DeFi.

25 Aug
2020
Sree
Undercollateralized Loans: Future of DeFi?
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DeFi is reshaping the financial ecosystem as we know it. Almost all financial products that are available with the traditional finance industry are decades old, and for the most part – have not made any substantial improvement during the same period.

Blockchain and cryptocurrency are able to bring a difference to this scenario. As cryptocurrencies rose to popularity and gained mainstream attention, they were deemed as a new asset class, which was indeed something that had not been seen in the last few decades.

The journey of cryptocurrency has now reached a new turning point with the introduction of DeFi or Decentralized Finance.

DeFi’s Rise to Popularity

DeFi is essentially a financial ecosystem with numerous financial products and services. Although products offered by DeFi resemble products in the traditional financial ecosystem, DeFi has been able to significantly innovate and modify these products, such as lending and savings accounts, in favor of the consumer.

On the back of fundamental properties of blockchain, like decentralization and public ledgers, and along with the more advanced concept of smart contracts, DeFi has been able to improve some of the underlying flaws of traditional financial products with a different user experience. 

Along with the improvements it has brought to technological parameters, DeFi has also provided better commercial viability to the consumer. The interest rates and yield for services like loans and savings accounts are overall better when compared to traditional financial products.

Taking into account the latest numbers, while the traditional investment methods like Bonds and savings accounts offer a yield ranging from less than 0% to ~2%, DeFi related services offer yield in the range of 8-10%.

The rise of demand for DeFi comes as no surprise in the current context, where many legacy investments such as government bonds, are providing a negligible or even negative yield. DeFi has managed to provide essential enhancements to both the technological parameters and monetary parameters of the services offered to consumers.

Since DeFi relies on blockchain technology: 

  • It eliminates the need for a third party.
  • It operates internationally, for almost anyone.
  • It stipulates minimum to no eligibility criteria. 

This ultimately makes DeFi a service that is inclusive of everyone , and with each passing day, a higher number of people around the world are transitioning into the decentralized future of blockchain, using DeFi as a gateway.

The initial success and popularity of DeFi have considerably improved the growth in the space. However, DeFi keeps on improving and evolving in its service offerings, and the latest addition to this list is Undercollateralized Loans.

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Undercollateralized Loans

Undercollateralized loans or lending is already being touted as the future of DeFi. Although it might seem like a farfetched idea, DeFi platforms have already started offering this service.

So what are undercollateralized loans and why are they important for consumers?

Anyone who has secured a loan both through a traditional channel or DeFi platforms will have heard about collateralized loans. Collateral is any asset that has a value and is accepted as a security by the lender from the borrower. Any loan that is sanctioned with the security of fully backed collateral is effectively deemed as a collateralized loan. In other words, the collateral more than covers the loan, or principal. 

Conversely, an undercollateralized loan is any loan that is not fully collateralized. That is to say that if the loan were defaulted, the collateral would not fully cover the principal. Although the concept of undercollateralized loans may raise some questions and concerns, it is conceived in a way to protect the interests of both the borrower as well as the lender.

Undercollateralized loans could be enabled through credit delegations. Credit delegations can be explained through a hypothetical scenario between Mary and Sam.

Let’s assume that Mary has deposited US$100,000 into a DeFi lending platform providing undercollateralized loans. Mary could use the DeFi platform to lend the whole amount using collateralized loans to other users of the DeFi platform and get a good return on her investment. However, Sam needs some urgent financial support, and Sam is well-known to Mary and is trusted by her. Hence to help Sam, who cannot obtain collateral to get his loan sanctioned, Mary helps him with an undercollateralized loan.

To achieve this, Mary will have to delegate her credit to a particular borrower, in this case, Sam. And once Mary delegates her credit, Sam can use the DeFi platform to obtain a loan without depositing collateral.

The critical factors that need to be accounted in these scenarios are:

  • Mary trusts Sam; it is one of the recommended criteria that credit delegation should only be provided to someone whom the lender can trust.
  • Secondly, both Sam and Mary have to be located in the same jurisdiction, so that in the event of a default, Mary can proceed with a legal procedure against Sam.

Undercollateralized loans can further increase the popularity of DeFi, as this new addition of product further improves and differentiates DeFi from traditional financial products.

Conclusion

DeFi is a relatively new product on the market, and it is continuously evolving for the better. So far, DeFi has been able to effectively expose and rectify faults in many legacy products and services. 

It is fair to say that undercollateralized loans, the latest addition to a long list of products from DeFi, can even further enhance this awesome byproduct of cryptocurrency for the better.

Since its emergence, DeFi related products have helped numerous people in need. And without a doubt, the introduction of undercollateralized loans will bring even more relief to those who lack any collateral.