Decentralized Finance, also referred to as “Open Finance” or “DeFi”1, has grown to become one of the core drivers of usage on the Ethereum network. At the core of DeFi’s principles is the provision of a brand new, permissionless financial service ecosystem without any central authority, available to everyone in the world. In this ecosystem, the user acts as his own custodian, maintaining full control over his assets, encouraging full ownership and access to all disintermediated marketplaces and platforms.
This report is the first article in our DeFi Series that will cover different platforms and protocols that aim at disrupting the existing financial industry and infrastructure. Specifically, this report will discuss the foundational cornerstones of DeFi: decentralized cryptoasset lending and borrowing platforms.
As of May 31st 2019, Ethereum dominates in amount of existing applications, transaction count, and volume traded/locked on existing platforms (e.g., Maker, Compound). As a result, Ethereum-based dApps will be the focal point of this report.
As loans have historically been built on a single pillar of trust between two parties, how do decentralized cryptoasset lending and borrowing platforms match loans between anonymous individuals with no predefined trust or relationship?
DeFi can be defined as:
“An ecosystem comprised of applications built on decentralized networks, permissionless blockchains, and peer-to-peer protocols for the facilitation of lending/borrowing or trading with financial instruments.”
Today, a large majority of Defi protocols are being built on Ethereum. Collateral locked on Ethereum-based DeFi applications are collectively worth over USD 500 million (more than 1.5 millions of ether), as of June 5th.
Bitcoin’s Lightning Network solution can be considered as a DeFi application running on the Bitcoin blockchain. As of June 5th 2019, the Lightning Network has its value locked worth around USD 8 million.
Regarding EOS, EOSRex enables users to borrow and lend EOSIO resources (e.g., CPU and Bandwidth/NET). Despite it being released a month ago, this single application has become the largest platform based on the total collateral value, with more than 90 million EOS being locked. Other platforms for EOS include a permissionless money-market protocol named BUCK Protocol that went live recently2.
Furthermore, other blockchains will also build decentralized applications, part of the Open Finance initiative3. For instance, Stellar aims at developing the world’s new financial system, but has yet to see increasing financial-related dApps created by third-party developers.
Another example is Ontology which recently partnered with Paxos, the stablecoin issuer, to release up to 100 million PAX tokens on its blockchain. In its press release4, Ontology mentioned “to explore application scenarios on Defi [...] beyond exchanges and are expected to launch the PAX token on Ontology in May”.
Regardless, this report will focus on Ethereum-based DeFi applications. What are the assets supported on these platforms and protocols?
A wide range of assets are being supported on Ethereum-based DeFi platforms. They can be classified in two main categories: native blockchain assets and non-native blockassets.
“Native blockchains assets are defined as assets whose value is not backed by any non-native blockchain asset such as a commodity, equity or fiat currency. Examples include Basic Attention Token (BAT) or OmiseGo (OMG).
These assets typically allow minting/burning of new assets on the blockchain (i.e on-chain creation of asset). Across the DeFi ecosystem, one of the core pillars (and conversely an example of a native blockchain asset) is MakerDao (MKR) and its Dai (DAI) stablecoin.
As a crypto-backed stablecoin, Dai’s value is pegged to the USD dollar through a complex collateralization mechanism and a stability fee that incentivizes market participants to arbitrage any long-lasting mispricing issues. This will be discussed further in the next section.
Other native assets are also used as a component of these applications, such as ERC-20 tokens on the Ethereum blockchain like Augur (REP), Basic Attention Token (BAT) or 0x (ZRP).
These native blockchain assets can be used as:
Interestingly, illiquid (native) blockchain assets cannot be used as collateral regardless of whether or not they are fungible or non fungible (e.g., CryptoKitties).
“Non-native blockchain assets include different assets that run on a public blockchain but whose value is collateralized by an other asset that is non-native to the blockchain, such as a commodity, equity or fiat currency.”
Some of the most popular non-native blockchain assets are stablecoins collateralized by fiat currencies on bank accounts such as USD Coin (USDC) or TrueUSD (TUSD).
What are the protocols and platforms running on the Ethereum blockchain for non-custodial lending and borrowing platforms?
In this section, only non-custodial platforms and protocols were included. As a consequence, it excludes platforms such as BlockFi or Nexo.
|NON-CUSTODIAL PLATFORM||DESCRIPTION||ASSETS SUPPORTED||AMOUNT LOCKED (USD MILLION)|
|Bloqboard||P2P lending/borrowing platform built on top of MakerDao and Compound protocols||BAT, DAI, REP, WETH, ZRX||-|
|Compound||P2P lending/borrowing platform||BAT, DAI, ETH, REP, USDC, ZRX||27.05|
|Dharma||P2P lending/borrowing platform. However the new platform shifted away from its initial vision and has become semi-centralized.||DAI, ETH, USDC||21.39|
|dYdX||Decentralized exchange for margin lending and derivatives||DAI, ETH, USDC||5.74|
|ETHLend||P2P crypto-lending marketplace where borrowers and lenders can set desired loan terms, and a set of accepted coins and corresponding rates that can be used as collateral||157 ERC-20 tokens See full list there||1.427|
|(Fulcrum (bZx)||Margin Lending and Borrowing platform||BAT, DAI, ETH, KNC, REP, USDC, WBTC, ZRX||0 (still in alpha and running on Ropsten Testnet Network)|
|InstaDApp||Decentralized Banking protocol integrated with different platforms such as Maker, Uniswap and Kyber||DAI, ETH, KNC, MKR, REP, USDC, TUSD, WBTC, ZRX||2.15|
|Lendroid||Margin Lending and Borrowing platform (functions supported: Collateralized Loan, Margin Trading, Auction Market and Governance)||Any ERC20-based token||Not built yet.|
|Maker||Borrow stablecoins (DAI) through overcollateralization||DAI, ETH||403.92|
|Marble||Open-source P2P lending on the Ethereum blockchain||-||Public beta.|
|Nuo Network||P2P lending and borrowing platform employing liquidity reserves to power borrowing and leverage/shorting||BAT, DAI, ETH, LINK, USDC, ZRX||7.14|
|Ripio Credit Network||P2P credit network lending and borrowing platform||Argentine pesos, MANA, RCN|
|Zerion||Decentralized Banking platform integrated with different protocols: Kyber Network, 0x Protocol, Compound, Dharma, Melon Port and Set Protocol.||BAT, DAI, ETH, REP, USDC, ZRX|
It is worth noting that other platforms have failed or seem to no longer be supported anymore, as illustrated by CDx.
The “Big 3” of MakerDAO , Dharma, and Compound represent nearly 80%8 of the total ETH locked in DeFi platforms and will be described in the next section.
In this section, the three largest platforms, mentioned in the previous section, will be discussed: Maker, Compound and Dharma. Interestingly they all have different models and as a result, offer interesting insights about how the general lending process can exist on non-custodial platforms.
In general, they rely on overcollateralization from borrowers as the key mechanism to initiate a loan and strict rules to decide whether the loan must be closed during the duration of the loan.
Maker is a unique “issuer”, in which an individual can borrow Dai, a stablecoin whose peg targets a value of 1 USD per token, directly by placing ETH in reserve in their collateralized debt position (CDP).
The Maker token (MKR) allows for individuals to participate in the operational earnings through “governance fees” that act as interest rates for the network. This structure is different from the peer-to-peer model, as it pools reserves together to actively issue coins, rather than transfer existing coins.
Unlike fiat-collateralized tokens, cryptoasset collateralized stablecoins rely on different mechanisms to maintain their peg against a fiat currency. Yet, it is worth mentioning that any stablecoin, regardless of its peg mechanism, has its intrinsic value fully dependent on the centralized decision-making process of central banks (e.g US Federal Reserve), which are in charge of monetary policy that ultimately impacts the relative value of the fiat currency against other currencies and assets.
In MakerDAO’s example, Dai a cryptoasset collateralized stablecoin that works with the Maker ecosystem, built on Ethereum. Using smart contracts written in Solidity, the Maker ecosystem currently allows Ethereum holders to park their Ethereum in a contract, in exchange for the ability to print or mint the DAI stablecoin, thus taking out a stablecoin loan against their volatile underlying collateral of ETH. It is worth noting that the Maker platform will soon allow borrowers to park multi-asset collateral in order to mitigate the volatility of a single asset, thus introducing diversification at the collateral level.
In Maker, loans are overcollateralized with the collateralization ratio being required, at the loan inception, to be above 150%.
Meanwhile, peer-to-peer pools can be separated into two types:
We will have a look at the two largest peer-to-peer platforms: Compound and Dharma.
In a majority of these platforms, the platforms are matching lenders and borrowers directly, with a spread between the interest rates, so that the protocol creator or platform creator, can sustain operations.
Compound is a protocol which creates money markets for various tokens, running on the Ethereum blockchain.
Each market is linked to a cToken (i.e., cBAT) that acts as the intermediary for any asset being lent on the protocol. Through the cToken, lenders earn interest that compounds over time. Specifically, interest rates are compounded at the block level. With a block being created on average every 15 seconds, the cTokens would increase continuously over the duration of the loan.
Within Compound, there is a withdraw function which allows users to convert the cTokens to the original assets (e.g., from cBAT to BAT).
Interest rates exist for each asset based on real-time market dynamics. When there is an excess of demand from borrowers, the interest rate would increase whereas an excess of lendable amount would lead to lower interest rates. Furthermore, the supply rate (i.e the lending rate) is always lower than the borrowing rate, by design, to create liquidity on the platform.
Dharma is a platform that allows users to borrow and lend several assets at a fixed interest rate for 90 days. Supported assets include Ethereum, USD Coin and Dai.
In short, this platform handles and matches trades manually without acting as custodian at any single point of time. A user can request to lend funds and then he/she will need to wait for their offer to be matched.
Interest rates are currently determined manually by the team in a black-box process. Interestingly, borrowing and lending rates are set equal which contrasts sharply with other platforms like Compound.
If a borrower decides to repay his loan before the maturity date, he must pay the entire interest on the loan over 90-day. As a result, the only incentive for a borrower (to repay the loan early) is to get full access to his collateral immediately.
|INSTRUMENT||DESCRIPTION||INTEREST RATE (%)|
|Fed Policy Rate||Interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis.||2.25-2.5%|
|LIBOR USD Overnight||Effective interest rate for interbank overnight loans.||2.36%|
|3-month US Treasury||Treasury yields refer to the return on investment on the U.S. government debt obligations.It has different annualized interest rates based on the maturity of each debt obligation (e.g., 3 months, 1 year).||2.37%|
|1-year US Treasury||-||2.31%|
|10-year US Treasury||-||2.18%|
|10-year Jumbo Rate||Fixed mortgage rate, assuming a very good credit score (FICO credit score of 740+) and single-family purchasing its primary residence.9||3.87%|
These traditional instruments (see table 2) essentially provide indication about “risk-free rates” in the US economy. Right now, these rates range between 2% to 3%.
In comparison to borrowing rates for collateralized stablecoins (i.e., USDC in table 3), digital asset borrowing and lending platforms offer borrowing rates that are above these benchmarks rates despite key advantages such as transparency in both the movement of funds and the underlying smart contract, greater platform utility and flexibility, far easier access for users.
|Platform||Custodial?||ETH lending||ETH borrowing||DAI lending||DAI borrowing||USDC lending||USDC borrowing|
Interest rates on Dai are higher than interest rates on USDC as USDC has no underlying price risk against USD and can always be redeemed for exactly a dollar. However it is interesting to put it perspective the lending and borrowing rates on Dai. As the lending and borrowing rates for stablecoins are today are well below the stability fee of 17.50% that is voted by market participants, and as such, Maker voters may decide to further lower their governance fee to close the difference between the equilibrium rates of other platforms to stay competitive.
Regarding Ethereum lending and borrowing rates, they are in line with future staking rewards when Ethereum transitions from PoW to PoS. Staking rewards are similar to the network’s inflation rate and as a result, the lending and borrowing rates are in line with the expected Ethereum staking rate range of 2 to 3%.
As Maker is the largest component of DeFi with dominance of almost 80% over the entire borrowing and lending ecosystem, the evolution of the total collateral in use across all non-custodial platforms can be mapped out.
Yet, Dai is one of the central components of the DeFi ecosystem running on Ethereum, below are some key metrics related to the largest cryptoasset-backed stablecoin.
Right now, around 1.5% of Ethereum’s total supply is locked on Maker.
As mentioned in the previous sections, Dai is one of the central components of the DeFi ecosystem running on Ethereum. Here are some key metrics related to the largest cryptoasset-backed stablecoin.
On May 31st 2019, Maker holders decided to cut the CDP interest rate for the first time, by -2%, to 17.5%. The CDP interest rate had increased from 0.50% to a historical high of 19.50% over the first five months of 2019.
As of today, Dai circulating supply is around 82 millions of units, decreasing in early 2019 in line owing to the sharp consecutive hikes in the stability fee (see chart 6).
Dai current stands as the 5th largest USD stablecoin by market capitalization, behind USD Tether (USDT), USD Coin (USDC), TrueUSD (TUSD), Paxos (PAX) but has recently outpassed Gemini Dollar (GUSD).
As Dai is currently well overcollateralized (with a network collateralization ratio above 480%12) above its minimum threshold, there is still potential for an increase in circulating marketcap, so long as the MKR governance decides to lift its maximum supply limit currently set at 100 million DAI. This, along with the future support of multi-asset collateral (or an increase in the total USD value of these underlying collaterals) could further push the circulating supply of the world’s largest crypto-backed stablecoin to new highs.
In this section, we will discuss the perspectives of Defi market participants, including what type of individuals/institutions may want to participate in these protocols, and their potential motivations to do so, such as arbitrage.
From a lender perspective, the key benefit is the ability to put existing capital to use and generate yields versus simply holding their assets (“basic HODL strategy”) in the long-term. The two key yields that users may see in this case are:
From a borrower perspective, there are several reasons why borrowing an asset through a decentralized protocol could be useful.
Assuming no transaction cost, an arbitrage opportunity exists if the following inequality is true:
borrowingRate (%) < lendingRate (%)
However, because all loans are overcollateralized in today’s existing protocols, the spread between borrowing and lending rates will never actually be zero. A more thorough equation can be written to account for additional fees such as transaction costs or gas fees:
lendingRate (%) - minOvercollateralizationRate (%) * borrowingRate (%) - aggregateFees (%) >0
with aggregateFees (%) being the sum of any additional fees such as gas fee or any transaction fee on the lending/borrowing platforms.
The product of the minOvercollateralizationRate (%) and the borrowingRate (%) assumes a 100% utilization rate of all the possible capital that can be lent. However, in practice, the network in aggregate tends to be overcollateralized at a much higher rate than the minimum, providing buffer room if the later leading to a less than 100% utilization rate.
|Platform||Average collateralization ratio|
|Compound v2||~ 400%|
Sources: dYdX, LoanScan.io
Currently, two major arbitrage opportunities exist on lending/borrowing platforms:
In this section, we compare the risks and advantages of these decentralized protocols compared to similar options and platforms from the traditional financial industry and with centralized cryptoasset custodial platforms.
Here are some of the benefits for the cryptoasset industry with these new decentralized, non-custodial platforms:
Specifically, these platforms & protocols offer several advantages against centralized banking platforms such as:
Custodial lending platforms refer to centralized platforms in the cryptoasset industry such as custodial lending platforms (e.g., BlockFi) or centralized exchanges (e.g., Bitfinex, Gate.io) allowing margin lending & borrowing on their exchanges.
Here are some of the general disadvantages against centralized lending solutions and custodial platforms, of the existing protocols/platforms running on the Ethereum blockchain:
Yet, if these disadvantages are important, most of them are explained by the nascency of the Open Finance industry. These applications and protocols remain in an experiment stage and are expected to mature, solving some of the key issues with the creation of insurance protocols, further gateway with the fiat world and new smart contract mechanisms to avoid the need for overcollateralization by design.
As we primarily discuss Ethereum-based applications in this report, some of the following issues on Ethereum itself could potentially create some issues for DeFi lending solutions:
Even if these issues are related to Ethereum specifically, similar issues can exist on any blockchain. Specifically, Ethereum sometimes faces these network performance issues owing to its popularity and usage. On the contrary, most of the other existing blockchains do not currently face scalability issues simply because they do not have enough traffic or are much more centralized by design, allowing for higher speeds and better performance.
While this report focuses on non-custodial platforms and options, there are different degrees of decentralization for lending protocols19. As such, platform-specific risks can be classified into two main categories: semi-centralized platform risks and fully decentralized platform risks.
Regulatory risks and taxation costs are relevant to consider if any individuals are using or relying on a custodial or centralized platform, even if to perform cross-platform arbitrage.
Here is an overview of some of the regulatory and taxation risks owing to the use of these platforms:
Ethereum is the largest programmable blockchain by market capitalization. As a result, it is no surprise that it is currently the standard default platform for many decentralized applications, which include lending and borrowing protocols such as Compound, Dharma and others. Soon, other programmable blockchains (such as EOS) are likely going to be increasingly used for many other decentralized lending protocols.
Owing to its nascency, the lending and borrowing industry carries a few risks that are expected to be mitigated as the industry matures (notably with increasing inflows and higher volumes). More products in a more mature industry should give more options for participants to select, giving users a more complete access to financial services.
Furthermore, these decentralized financial platforms may be a foundation or data point for centralized institutions to make their access decisions, hopefully leading to greater access to financial services through increased competition for traditional financial players, the gatekeepers of the financial world today.
While Quorum, JP Morgan’s permissionless fork of Ethereum, is being developed with initiatives such as JPM Coin, Ethereum remains the pacesetter of all blockchains for decentralized applications that will unbank many individuals.
DeFi, as illustrated by these lending and borrowing platforms, appears as one of the best use-cases of blockchain technology which could reach up to billions of users across the globe and allow access to basic financial services at efficient rates.