When you want to borrow crypto on a platform set up for that purpose, you often have to secure collateral. There is no intermediary, so users must be able to trust each other. However, it ensures that not everyone can borrow crypto. In most cases, the rich can borrow even more, while the poor are left out.
Many parties are working on finding solutions. They do this by developing new protocols that contribute to the issuance of undercollateralized loans. It is possible to take out a crypto loan without having to pay full (or no) collateral.
Crypto Lending #
Borrowing and lending crypto is an important part of DeFi (Decentralized Finance). There are many different platforms where you can lend cryptocurrencies to others, or borrow crypto from other people. When you lend crypto, you receive interest on the lent crypto. This interest is paid by the people who borrow the crypto. They ultimately have to pay interest on the loans. Within crypto we call this ‘Lending’.
What are Undercollateralized Loans? #
Undercollateralized loans are crypto loans without collateral or collateral that is less than the value of the borrowed assets. Normally you have to hold crypto as collateral before you can take out a loan. Because everything works in a decentralized way, this is necessary to build trust. However, it ensures that not everyone can take out a loan. You only need to own just enough crypto. This creates a gap between rich and poor.
With undercollateralized loans it is possible for both rich and poor to borrow cryptocurrency. According to many people, undercollateralized loans are not a substitute for overcollateralized loans. Instead, a completely new market that is more widely spread is being addressed.
At first glance it may seem impossible. Because how do you ensure that people lend their crypto when others have no or lower collateral to secure? Of course, you don’t want someone not to pay back your cryptocurrencies. However, there are already several protocols that have made it happen.
What undercollateralized loans protocols are there? #
There are several protocols that offer undercollateralized loans. They all do this in a different way, which allows us to divide these protocols into different categories. Below you can see which categories these are, and which protocols belong to them.
Crypto Native Credit Scores #
Crypto native credit scores are ideal for personal loans and microfinance. The idea behind this model is to build an on-chain identity for every user. The history of users is saved, in order to get a better picture of the behavior of users.
This is necessary to determine whether someone should qualify for a loan. When it appears that someone has not paid (on time) several times in the past, these users can be banned from future loans. After all, no one likes defaulters.
This concerns data from historical loans, yield farming, trading activities, participation in governance, etc. At the same time, the privacy of users must be sufficiently guaranteed. Some protocols solve this by using technologies such as Zk proofs. The authorized parties can then only see the results, while other data remains protected.
Crypto native credit scores allow people and protocols to see if someone is eligible for a loan. They then do not have to pay full collateral, which means that protocols within crypto native credit scores contribute to the development of undercollateralized loans.
These are well-known crypto native credit scores protocols:
- Ledger Score (LED);
- Credit mark (CMK);
- EasyFi (EZ);
- Wing (WING);
- Zoracles (ZORA);
Third Party Risk Assessment #
Third-party risk assessments are ideal for personal lending, microfinance, and decentralized prime brokerage. The advantage of this type of loan is that the risk is divided, so that users run a much smaller risk. This makes it attractive to use third-party risk assessments.
Under this model, a third party (not a borrower or lender), called an assessor, is chosen to perform a credit assessment. They will be rewarded for this, but they will also have to stake a number of assets. Should a default occur, their stake will be removed first.
This model makes it possible to borrow crypto without having to pay the full collateral. That offers many possibilities. At the same time, an on-chain credit scoring system is being built. Should a user not pay his loans, this will be saved. It then becomes increasingly easier for parties that carry out credit assessments to refuse defaulters.
The biggest disadvantage of this system is in the first months or years. At that time, no system with credit scores has been built up, which makes it difficult to assess whether someone may be eligible to take out a loan.
Since users are not required to pay full collateral, third-party risk assessment loans belong to undercollateralized loans.
These are well-known third-party risk assessment protocols:
- Goldfinch (GFI);
- Maple (MPL);
- TrueFi (TRU);
- Bloom (BLOOM).
Flash Loans #
Flash loans can be used for arbitrage, collateral swaps and liquidity. The advantage is that all parties involved have their assets back almost immediately and the risk that they run is small. However, flash loans often cannot be used for personal purposes.
With a flash loan, the borrowed assets must be repaid in the same transaction. This is therefore not useful if you want to take out a loan for a longer period of time. Instead, flash loans are ideal for traders who want to take advantage of small price fluctuations between different DEXs in combination with leverage (margin trading).
With a flash loan you do not have to secure collateral that is higher than the loan amount. Therefore, flash loans belong to undercollateralized loans.
These are well-known flash loans protocols:
- Aave (AAVE);
- dydx (DYDX);
- Equalizer (EQZ).
Personal Network Bootstrap #
The name already gives it away: personal network bootstrap protocols are ideal for personal loans. The chance of non-payment with these types of protocols is also extremely low. People who want to borrow crypto will first have to be added by members of the lending pool. This means that the platform grows organically, much like a network.
There is a lot of trust between the members of the pool. Everyone knows each other, which makes it easier to keep defaulters out. Still, you would think that it is difficult to keep defaulters out in this way. After all, anyone can add and accept new members. Many protocols have come up with something for that.
If you added a defaulter, you could be penalized for this. That’s why it can become an expensive joke when you invite people you don’t know. The risk is simply too great.
These are well-known personal network bootstrap protocols:
- Acropolis (AKRO);
- Union (UNN);
- Aave (AAVE).
Real World Asset Loans #
Unlike other protocols, you could use real-world asset loans for a mortgage, for example. In fact, you can use these types of loans for all real-world assets. Quite unique, as the funding takes place entirely on the blockchain.
The real-world asset loans are represented as NFT on the blockchain. The NFTs partly serve as collateral for the loan. You can therefore compare this with mortgages issued by banks. With these types of mortgages, the buildings are also the collateral for the loan.
If the user who has borrowed money is no longer able to pay his loan, the money could be repaid with the NFT. These can be resold. The buyer of the NFT then buys the title deed of the underlying real-world asset.
The biggest challenge is mainly in liquidity and regulation. It is easy to say that a certain NFT represents the title deed of a house, but local laws and regulations must be geared to this. In the Netherlands, for example, NFTs are not yet regarded as legal proof of ownership. A lot will therefore have to change before these types of loans can also work on a large scale.
These are well-known real-world asset loans protocols:
- Centrifuge (CFG);
- OpenDAO (SOS);
- RealT (REAL).
NFTs as Collateral #
There are also protocols where you can use NFT as collateral for a loan. NFTs have become very popular in recent years, and many of these types of tokens have increased in value. It may therefore be attractive to use these tokens for Lending.
Although it is a unique idea, it remains to be seen whether this will work. The value of an NFT is mainly based on the hype. The value of NFT art can collapse like a house of cards quite easily. This makes it difficult to attach a value to the NFTs that are set as collateral.
Nevertheless, we see that interest in these types of loans is increasing. NFTs are popular, and people want to use them for as many purposes as possible.
These are known NFTs as collateral protocols:
- Helio (HLO);
- Lendroid (LST);
- Stater (STR);
- Aave (AAVE);
Off Chain Credit Integration #
For personal loans and microfinance, off-chain credit integration is very useful. This kind of protocols have a lot of data from users and can make connections between other protocols. This makes it easy to learn a lot about certain users.
With off-chain credit integration, data stored on central servers is integrated into the blockchain. There is of course much more data about people available off-chain than is the case on-chain. Banks, insurance companies and other financial institutions keep track of people’s behaviour. They do this to determine whether someone should be allowed to access certain services.
If it turns out that someone never pays their taxes and premiums on time, a landlord could exclude someone. The chance that the potential tenant does not pay his rent on time is too great.
Moving this kind of data to the blockchain makes it easier to determine whether someone should be allowed to get a crypto loan. People who prove to be creditworthy then do not have to use any or considerably less collateral.
These are well-known off-chain credit integration protocols:
Digital Asset Loans #
Digital asset loans protocols are ideal for leveraged trading. This makes these types of protocols look a lot like flash loans. The difference, however, is that the purchased assets are placed in a smart contact until the loan is paid off. If it turns out that the trade does not go well, the contract can liquidate the position after which the loss is covered by the protocol. The full amount is then refunded to the lender. So, he doesn’t have to worry about a refund.
These are well-known digital asset loans protocols:
With undercollateralized loans it is a lot easier to borrow crypto. You don’t have to put in any (or much less) collateral. There are different categories within undercollateralized loans. There are dozens of protocols that belong to this, the most important of which you have read above.