I have no crystal ball and no prophetic talents, but I do have access to some of the brightest minds in DeFi and a news feed full of builders in the Web 3 space, so let’s tap into that mind share and take a look at the future of lending and borrowing in DeFi.

Past and Present of DeFi Lending

The summer of 2020 also referred to as “DeFi Summer ‘’ brought the world of decentralized finance (DeFi) to the mainstream of crypto. Protocols such as: Compound, Aave, and Alchemix made waves across the Web 3 industry. These protocols allowed permissionless lending and borrowing to take place with notable celebrities from the world of traditional finance (like Mark Cuban) and crypto (such as Vitalik Buterin) to come out in support of these new financial tools available to the world. DeFi protocols have continued to iterate on lending and borrowing by allowing more collateral types, exotic token pairs, and even self repaying loans with Alchemix.

The majority of these tools require you to overcollateralize, meaning if you want to borrow $100 of stablecoins, you need to deposit $150 or more of crypto collateral to the lending protocol. This ensures your loan amount stays collateralized to at least the value of the loan and if your loan were ever to approach that threshold, the smart contract sells your collateral to recoup the loan (plus some fees of course). What if in the future you could borrow without posting collateral?

DeFi-Nostradamus’ View on the Future of DeFi

One such future might be just around the corner with “credit-based” DeFi loans; similar to current bank loans, these would be made with no collateral and the interest rate would be variable based on one’s credit worthiness. The idea of a “no collateral loan” is not groundbreaking in the traditional finance space where a bank can simply pull your credit from a reporting agency. But how could it be accomplished in the pseudonymous world of multiple wallet addresses and cartoon character avatars?

Three mechanisms are currently being tested to allow for these type of loans:

Flash Loans: These are already in use and have been expanding across DeFi. A flash loan is simply a loan that is taken and repaid in the same block; this allows users of these loans to arbitrage price differences across assets or protocols. These are sophisticated tools used mostly by crypto funds via the use of bots. A fee is paid for the temporary use of capital and all transactions are settled at once in a single block. As bots and the tools around block construction get more sophisticated the ability to use flash loans will become more and more useful for sophisticated actors.

With the ETH 2.0 merge around the corner a new actor will enter the fray of validators: “block builders”. These block builders will get to order the transactions in each block allowing the ability for arbitrage spreads in trades, these flash loans will be a powerful tool for these actors to extract extra value when validating a block.

Third Party Assessment: This is a similar model to the current financial system of “credit agencies” that monitor and maintain a database of everyone’s credit score, these agencies are queried by lenders to determine one’s credit worthiness; a better score means a better chance of being approved for the loan and a lower interest rate. This is just bridging the world of centralized finance into the decentralized world. The problem is bootstrapping enough of these third party actors to build a robust credit system in DeFi and how to uphold the ethos of “decentralization” when this system would rely on centralized third party actors.

Crypto Native Credit Scores: In the blockchain space an idea being tested is “on chain credit worthiness”; this would allow a lender to examine all the activity of your wallet to determine if you are the type of person to repay your loan, what is the risk of default, and what rate to charge you for the loan. A glaring problem with this system is how to punish a bad actor for not repaying the loan and what is to stop a bad actor who could simply use a new wallet and never need to deal with the repercussions of the default. The future of crypto native credit scores will require creative thinking in solving these glaring issues.

One solution is using a “zero knowledge proof of off chain data” where your real world ID could be linked to an encrypted Zero Knowledge Proof. Allowing your wallet to be associated with your real world identity without the other party knowing who you actually are. This would allow your lending and borrowing history to be tied to each wallet you use and would help create a trusted, but decentralized profile for each wallet associated with you.

Another idea being used is “on chain credit integration” using a KYC (know your customer) credit score attached to a zero knowledge proof tied to your wallet or online identity; this requires a third party, but would allow you to choose your company of choice and would shield your personal information from lenders (imagine doing one credit check with a company of your choice and then using it for multiple loan companies who never know who you actually are).

DeFi-Nostradamus Peers Deeper Into the Future

Credit by Social Reputation

A social reputation system is also being theorized, referred to as “A Personal Network Bootstrapping Collective”. This is a network effect idea where only trusted actors could participate, once a wallet address has been deemed a high credit person they could invite a friend to join the network. This makes the credit worthy wallet holder reputationally liable for the invitee, an example would be: you invite your friend to the network, they borrow some money, and then default on it; your friend would be out of the collective and your reputation would take a hit (like your credit score going down), this would affect your borrowing ability and interest rates on current loans (or could even get your thrown out of the club).

NFTs as Collateral

A popular tool of the rich is to buy assets like fine art, borrow money against the price of the art (for a fee of course), and use the money for other things; this allows you to access the money locked in an asset without paying those pesky capital gains taxes. Enter NFT borrowing! This system allows a user to lock up an NFT in a smart contract and borrow money against it for a fee (of course) and a monthly interest payment; this is very similar to the current model of over collateralized crypto borrowing mechanisms such as MakerDAO and Aave.

Under this system, you could only borrow a portion of the value of the NFT and if the price of your NFT ever drops to 100% of the loan value, the protocol would sell your NFT and repay the loan to itself (plus a fee of course!). Unlike most tokens in crypto with an active price oracle that transmits the current price of each token to a smart contract, NFTs are only worth what another party is willing to pay for them. NFT Tech is new liquid matching engine that utilizes a bid order book for NFTs to transmit prices of popular NFT projects to smart contracts directly; this opens up NFTs for uses in many of DeFii’s current protocols and systems.

Real World Assets in DeFi

Real Estate started making headlines across the globe as companies began to “tokenize” real estate. Accomplished by selling a property to a company (such an LLC) and then creating an NFT or token that represents ownership of the company on the block chain. This is also being done with a staggering number of real world items such as stable coins backed by precious metals, venture investment shares as NFTs, music royalties, and even cars! Companies like Centrifuge allow you to bridge real world asset ownership into NFTs and then use them for borrowing and lending in places such as Aave and MakerDAO.

To get these real world assets onto the blockchain the owner must “hash” the ownership document onto the blockchain and then an NFT is created once the hash of the document is locked into the “Tinlake” dApp. This allows users across the globe to access capital that may not have been possible before, this type of system opens up a 100 trillion dollar opportunity by bringing real world assets onto the block chain.

Toward Better Lending and Borrowing

DeFi has long been an innovation launch pad for new techniques and products across Web3 since its inception, and now DeFi entrepreneurs are actively building new protocols for lending. While we are theorizing about on-chain credit scores, social capital investment clubs, borrowing against real world assets, or tokenizing your home, the builders in this space are busy creating. The innovations in lending and borrowing continue to improve, month after month, and the future still looks bright for a Bankless world!

I have no crystal ball and no prophetic talents, but I do have access to some of the brightest minds in DeFi and a news feed full of builders in the Web 3 space, so let’s tap into that mind share and take a look at the future of lending and borrowing in DeFi.

Past and Present of DeFi Lending

The summer of 2020 also referred to as “DeFi Summer ‘’ brought the world of decentralized finance (DeFi) to the mainstream of crypto. Protocols such as: Compound, Aave, and Alchemix made waves across the Web 3 industry. These protocols allowed permissionless lending and borrowing to take place with notable celebrities from the world of traditional finance (like Mark Cuban) and crypto (such as Vitalik Buterin) to come out in support of these new financial tools available to the world. DeFi protocols have continued to iterate on lending and borrowing by allowing more collateral types, exotic token pairs, and even self repaying loans with Alchemix.

The majority of these tools require you to overcollateralize, meaning if you want to borrow $100 of stablecoins, you need to deposit $150 or more of crypto collateral to the lending protocol. This ensures your loan amount stays collateralized to at least the value of the loan and if your loan were ever to approach that threshold, the smart contract sells your collateral to recoup the loan (plus some fees of course). What if in the future you could borrow without posting collateral?

DeFi-Nostradamus’ View on the Future of DeFi

One such future might be just around the corner with “credit-based” DeFi loans; similar to current bank loans, these would be made with no collateral and the interest rate would be variable based on one’s credit worthiness. The idea of a “no collateral loan” is not groundbreaking in the traditional finance space where a bank can simply pull your credit from a reporting agency. But how could it be accomplished in the pseudonymous world of multiple wallet addresses and cartoon character avatars?

Three mechanisms are currently being tested to allow for these type of loans:

Flash Loans: These are already in use and have been expanding across DeFi. A flash loan is simply a loan that is taken and repaid in the same block; this allows users of these loans to arbitrage price differences across assets or protocols. These are sophisticated tools used mostly by crypto funds via the use of bots. A fee is paid for the temporary use of capital and all transactions are settled at once in a single block. As bots and the tools around block construction get more sophisticated the ability to use flash loans will become more and more useful for sophisticated actors.

With the ETH 2.0 merge around the corner a new actor will enter the fray of validators: “block builders”. These block builders will get to order the transactions in each block allowing the ability for arbitrage spreads in trades, these flash loans will be a powerful tool for these actors to extract extra value when validating a block.

Third Party Assessment: This is a similar model to the current financial system of “credit agencies” that monitor and maintain a database of everyone’s credit score, these agencies are queried by lenders to determine one’s credit worthiness; a better score means a better chance of being approved for the loan and a lower interest rate. This is just bridging the world of centralized finance into the decentralized world. The problem is bootstrapping enough of these third party actors to build a robust credit system in DeFi and how to uphold the ethos of “decentralization” when this system would rely on centralized third party actors.

Crypto Native Credit Scores: In the blockchain space an idea being tested is “on chain credit worthiness”; this would allow a lender to examine all the activity of your wallet to determine if you are the type of person to repay your loan, what is the risk of default, and what rate to charge you for the loan. A glaring problem with this system is how to punish a bad actor for not repaying the loan and what is to stop a bad actor who could simply use a new wallet and never need to deal with the repercussions of the default. The future of crypto native credit scores will require creative thinking in solving these glaring issues.

One solution is using a “zero knowledge proof of off chain data” where your real world ID could be linked to an encrypted Zero Knowledge Proof. Allowing your wallet to be associated with your real world identity without the other party knowing who you actually are. This would allow your lending and borrowing history to be tied to each wallet you use and would help create a trusted, but decentralized profile for each wallet associated with you.

Another idea being used is “on chain credit integration” using a KYC (know your customer) credit score attached to a zero knowledge proof tied to your wallet or online identity; this requires a third party, but would allow you to choose your company of choice and would shield your personal information from lenders (imagine doing one credit check with a company of your choice and then using it for multiple loan companies who never know who you actually are).

DeFi-Nostradamus Peers Deeper Into the Future

Credit by Social Reputation

A social reputation system is also being theorized, referred to as “A Personal Network Bootstrapping Collective”. This is a network effect idea where only trusted actors could participate, once a wallet address has been deemed a high credit person they could invite a friend to join the network. This makes the credit worthy wallet holder reputationally liable for the invitee, an example would be: you invite your friend to the network, they borrow some money, and then default on it; your friend would be out of the collective and your reputation would take a hit (like your credit score going down), this would affect your borrowing ability and interest rates on current loans (or could even get your thrown out of the club).

NFTs as Collateral

A popular tool of the rich is to buy assets like fine art, borrow money against the price of the art (for a fee of course), and use the money for other things; this allows you to access the money locked in an asset without paying those pesky capital gains taxes. Enter NFT borrowing! This system allows a user to lock up an NFT in a smart contract and borrow money against it for a fee (of course) and a monthly interest payment; this is very similar to the current model of over collateralized crypto borrowing mechanisms such as MakerDAO and Aave.

Under this system, you could only borrow a portion of the value of the NFT and if the price of your NFT ever drops to 100% of the loan value, the protocol would sell your NFT and repay the loan to itself (plus a fee of course!). Unlike most tokens in crypto with an active price oracle that transmits the current price of each token to a smart contract, NFTs are only worth what another party is willing to pay for them. NFT Tech is new liquid matching engine that utilizes a bid order book for NFTs to transmit prices of popular NFT projects to smart contracts directly; this opens up NFTs for uses in many of DeFii’s current protocols and systems.

Real World Assets in DeFi

Real Estate started making headlines across the globe as companies began to “tokenize” real estate. Accomplished by selling a property to a company (such an LLC) and then creating an NFT or token that represents ownership of the company on the block chain. This is also being done with a staggering number of real world items such as stable coins backed by precious metals, venture investment shares as NFTs, music royalties, and even cars! Companies like Centrifuge allow you to bridge real world asset ownership into NFTs and then use them for borrowing and lending in places such as Aave and MakerDAO.

To get these real world assets onto the blockchain the owner must “hash” the ownership document onto the blockchain and then an NFT is created once the hash of the document is locked into the “Tinlake” dApp. This allows users across the globe to access capital that may not have been possible before, this type of system opens up a 100 trillion dollar opportunity by bringing real world assets onto the block chain.

Toward Better Lending and Borrowing

DeFi has long been an innovation launch pad for new techniques and products across Web3 since its inception, and now DeFi entrepreneurs are actively building new protocols for lending. While we are theorizing about on-chain credit scores, social capital investment clubs, borrowing against real world assets, or tokenizing your home, the builders in this space are busy creating. The innovations in lending and borrowing continue to improve, month after month, and the future still looks bright for a Bankless world!