Decentralized finance (“DeFi”), also known as open finance, is one of the areas of cryptocurrency that has received notable attention so far. At a high level, the purpose of DeFi is to create many of the financial systems we have today (eg, lending and derivatives), but in an automated way and without the need for intermediaries.

Since DeFi is still in its early stages, the content of this article is mainly my thoughts on the development of DeFi and some interesting possibilities that may arise.

1. Mortgage

A major complaint about DeFi is the need for over-collateralization to get a loan (MarkerDAO minimum collateralization ratio of 150%).Source: DeFi Pulse

Source: DeFi Pulse

This is often done for leverage, especially during bull markets. For example, you lock up $200 of ETH to borrow $100 of DAI, which you can then use to buy another $100 of ETH. Another main reason is that people don't want to sell their coins (which would involve paying taxes), so they may prefer to use collateral to borrow money.

Other reasons people use DeFi is that it's a more streamlined process than the traditional financial system because users don't have to go through a complicated onboarding process for real-name authentication (I think this aspect will eventually change with many projects). In addition, some people who cannot use traditional financial services may also find the benefits of DeFi, but I believe that once the mortgage rate drops, the use of DeFi will greatly improve.

It’s worth noting, though, that we’re still in the early days of DeFi.Complaints about overcollateralization are due to the lack of proper decentralized identity and reputation systems in earlier systems. Without these, and a legal system to fix the problem, the only way to reassure lenders is to overcollateralize.

Whether people think the system should exist or not, the need for it is clear, and existing DeFi projects are actually easy to use. Sometimes borrowers don’t have good options if they don’t want to sell their cryptocurrencies, especially if they are excluded from the traditional financial system.

The possible options for lenders are to not earn interest on the coins they hold, or to hold them in a bank account in fiat currency, and the bank will lend those deposits out and take most of the interest earned. Even though we still have a long way to go, DeFi is an important step for both parties.

Once better identity and reputation systems are added to DeFi, we will see lower collateral requirements.At present, there are multiple credit management departments in the United States (such as Experian, TransUnion, Equifax), and they can provide personal credit information to banks and other institutions.

Credit bureaus can put groups like foreigners and young people at a disadvantage. Peer-to-peer lending services like Lending Club solve the problem of traditional financial services relying solely on FICO scores by providing more data on home ownership, income and hours worked.

Decentralized identity and reputation systems can provide similar things, including social media reputation, past loan repayments, guarantees provided by other reputable users, and so on. However, such an approach requires a lot of trial and error, such as which data to use and how much collateral is required.

BTCJam (District Note: Peer-to-peer bitcoin lending platform, closed) made such an attempt a long time ago. They use their own proprietary credit scores and offer interest rates accordingly. Developers developing DeFi systems can learn from the experience of BTCJam to improve.

2. Composability

One of the most unique aspects of DeFi is composability. Protocols can be assembled like Lego bricks to create something entirely new. Even the mortgage design is being applied to ultra-liquid systems. For example, you can take collateral from one protocol and lend it out on another.

I am very concerned about this because the cumulative risk of smart contracts is very high, and the whole point of overcollateralization is to prevent borrowers from not being able to return the principal of using collateral. If the collateral is lent elsewhere and something goes wrong, then that collateral is no longer useful.

As much as I'm not comfortable with this "ultra-liquid" system, I think it's inevitable that people will start experimenting with the concept due to the inefficiency of having a lot of money locked up. I just wish people could regulate themselves, maybe set thresholds like minimum collateral ratios.

There are many more platforms where users can deposit their funds and then lend them out on DeFi protocols with the highest interest rates (such as MetaMoneyMarket) so that users don't have to manage it themselves. Users can also carry out diversified customization.

For example, you can set the loan amount of funds to a maximum of X% to reduce smart contract risk, only lend to specific agreements, and return funds if the interest rate is lower than Y%, or provide different stablecoins based on interest rates (such as USDC to DAI) option.

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Wealthfront's Risk Tolerance Test

3. Assets

I really like bringing more tokenized assets like Bitcoin into DeFi. In a bull market, I believe there is a lot of demand for Bitcoin leverage to use DeFi, if it is easy to use and cheap to create and redeem.

I believe cryptocurrency custodians are best able to offer a centralized version of this product, since the funds are locked away by their customers. Many large investors are required to secure their funds with a qualified custodian, so for some, self-regulation is not required.

This could be another revenue stream for custodians, who can represent the assets being escrowed in tokens (tokens) and then allow people to trade them. WBTC already exists, but high fees prevent its mass adoption. I think those fees will come down as competition and users increase.

For example, Coinbase Custody launched in July 2018 and charged 10 bps per month, and in August 2019, charged 50 bps per year, which I believe will decrease further over time.Ultimately, decentralized versions of tokenized assets will co-exist with centralized versions.

Currently, the vast majority of people using DeFi are people who are relatively familiar with cryptocurrencies. In the future, though, traditional investors may start using DeFi or DeFi-like systems. Now stablecoins like USDC appear on DeFi platforms and are used for lending.

I can imagine a day when stocks, real estate, and bonds used by traditional investors are tokenized as collateral for leverage or loans.However, I think these systems will be highly regulated because traditional investors won't use it. It may look like a form of DeFi that we have now, which is more efficient and cheaper than traditional systems, but has more regulation than DeFi.

4. Risk

As alluring as DeFi is, it's important to acknowledge the risks it poses. Since these systems are new and some have only been in operation for a few months, smart contracts present obvious risks. Smart contract risk is compounded when these protocols interact with and rely on each other. If this risk did not exist, there would be a lot of borrowing and lending on DeFi protocols right now.

There is also the risk of the type of collateral used to back the loan. Even overcollateralization cannot offset the volatility of some assets if the price falls so fast that a margin call still cannot cover the entire amount of money borrowed. With reasonable overcollateralization ratios and acceptable collateral types currently available on some platforms, potential loan defaults are not as much of a concern as smart contract risks.

I also think that as the transaction size gets bigger, DeFi will have more regulation, such as requiring KYC, which may reduce the liquidity of some projects and make it more difficult for people without proper documentation to use.This will vary based on factors such as product type, jurisdiction, and degree of decentralization (although people use "DeFi", many projects are not decentralized at this stage).

Given these risks, there has been discussion around the use of decentralized insurance to hedge risks. You can do this through a prediction market such as Augur, where you bet on the existence of a problem with the smart contract on the protocol, and if there is a problem, then you get paid. However, it is worth noting that these methods still have greater smart contract risks.If the scale of DeFi becomes large enough, traditional insurance companies may also provide products.

V. Conclusion

V. Conclusion

———— District brother’s comment: ————

DeFi's mortgage assets have increased significantly in the past few months, but the reason is the substantial appreciation of ETH. Compared with the appreciation of ETH, the growth of ETH mortgage volume is not too prominent.

The figure below shows the growth curve of DeFi collateral value after removing EOS, BTC, and Edgeware. It can be seen that the lock-up value has increased rapidly since February.

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Data source: DApp Total

For the problems faced by DeFi, contract risks and more users, there is no good solution yet.

At this stage, many DeFi products are relatively short-lived, and there are countless cases of smart contracts being attacked, allowing users to completely hand over large sums of money to the code. DeFi products still need a longer time to prove their security and reliability.

Different from Internet products, small steps and quick iterations of financial products are not feasible. A small negligence in financial products can wipe out a large amount of funds and cause serious consequences.If you want more people to use your financial products, you must first solve the problem of user trust. This is also an important prerequisite for gaining more users in addition to lowering the threshold for use.

As mentioned in the article, the high mortgage rate is also one of the limitations that hinder the widespread use of DeFi. The article proposes a solution,Through a decentralized identity and reputation system, such as social media reputation, past loan repayment, and guarantees provided by other reputable users, users are given credit scores, thereby reducing the mortgage rate and greatly increasing the utilization rate of DeFi .

What do you think of this point of view? Through the decentralized identity and reputation system, as well as guarantees provided by other users, while reducing the mortgage rate of DeFi products, without greatly increasing its risks, how long do you think this vision can be realized?

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Author: Linda Xie, co-founder of Scalar Capital, former Coinbase product manager and AIG portfolio risk analyst, 0xProject consultant, and helping GiveCrypto popularize encryption.

Disclaimer: This article is the author's independent point of view, and does not represent the position of the Blockchain Institute (public account), nor does it constitute any investment opinion or suggestion. The picture comes from the Internet.

Disclaimer: This article is the author's independent point of view, and does not represent the position of the Blockchain Institute (public account), nor does it constitute any investment opinion or suggestion. The picture comes from the Internet.

Source: https://lindajxie.com/2019/08/07/the-future-of-decentralized-finance/