At the moment, a majority of cryptocurrency lending has been largely centralized. In other words, blockchain lending companies have a central authority who dictate who to lend to. However, a different class of blockchain lender platforms is promising decentralized lending powered by smart contracts. Specifically, these blockchain lending platforms are being on top of Ethereum’s blockchain, allowing the platform’s users to borrow and lend other users, in a completely decentralized manner.
What is trust-less blockchain lending?
Since Bitcoin’s inception, innovation in the blockchain space had all to do with creating digital currencies. This is to say, blockchain use largely involves the creation, storage, and transaction in digital money. Afterward, blockchain innovation led to innovative ways of sending money across borders, driving up demand for financial services powered by Bitcoin. Similarly, demand for blockchain use in lending agreements, powered by smart contracts has increased.
As a result, cryptocurrencies, especially ETH (Ether), have found utility in credit markets. In particular, long term crypto holders can generate passive income from the value of their crypto-assets, by lending out their assets to peers. Consequently, the long term holders, in this case, the lender, receives compensation. In this regards, compensation is in the form of the time value of their assets (an interest rate).
For this reason, secured lending on blockchain has emerged as one of the most popular and fast-growing use cases for cryptocurrencies. To illustrate this, Genesis Capital, a crypto lender, in 2018 reportedly processed over $1.1 billion in loans. Additionally, MakerDAO, a decentralized crypto lender, reportedly processed approximately $200 million in loans.
How does decentralized lending in blockchain work?
Similar to traditional lending, cryptocurrency lending requires the borrower to crypto-secure the loan. In other words, the borrower has to post a crypto-asset as collateral in case the borrower fails to pay the loan. The borrower will often receive the loan in the form of fiat currency or a stablecoin such as Tether (USDT). Also, borrowers in a majority of crypto-lending platforms, have to provide more collateral than the value of the loan. The reason for this requirement is to protect the lender from a loss that can be derived from a drop in market value.
Custodial and Non-Custodial Lenders; how they differ.
In a nutshell, crypto-asset secure loans fall into two groups: custodial and non-custodial. Custodial blockchain lenders are crypto-lenders who lending assets from trusted third parties. On the other hand, non-custodial lending platforms allow borrowers to engage directly with lenders through smart contracts.
While centralized authorities in custodial crypto-lending have a say in interest rates, smart contracts dictate the interest rate in non-custodial crypto-lending. Since a smart contract is authoritative in non-custodial crypto-lending, they retain custody of the crypto-assets as collateral. As a result, the counterparty malfeasance is impossible.
Thus, these crypto-assets are in escrow in the smart contract for the entire life cycle of the loan. Hence, when a borrower defaults, the smart contracts automatically sells the underlying crypto-asset through a decentralized exchange, to recover the principal and loan interest.