Over the past year, we have seen the crypto economy expand exponentially as heaps of money poured into various cryptocurrencies, decentralized finance (DeFi), non-fungible tokens (NFTs), crypto indices, insurance products and decentralized options markets.
The total value locked (TVL) in the DeFi sector across all chains has grown from $18 billion at the start of 2021 to $240 billion in January 2022. With so much liquidity in the ecosystem, the crypto lending space has also increased significantly, from $60 million at the start of 2021 to over $400 million by January 2022.
Despite the exponential growth and innovation of DeFi products, the crypto lending market is still limited to tokenized loans, i.e. pledging one cryptocurrency as collateral to borrow another cryptocurrency. .
There are a few platforms such as Nexo and Genesis that provide NFT-backed loans, but the service is primarily aimed at institutional clients with top-notch NFTs. For the retail masses, there isn’t much more than token-backed loans.
If the crypto-economy wants to reach a size compatible with any real economy, it will have to reach the mass of retail consumers and be able to offer them financing options.
Here are the essential components that must develop before the crypto banking infrastructure can compete with that of banks.
Diversity of goods and services
One of the most common questions asked by someone who is new and wants to get into the crypto economy is: what can I buy? In the current infrastructure, there is not much other than NFTs, DeFi products, staking and providing liquidity.
In a traditional economy, currencies exist because the exchange of goods for services, or vice versa, usually does not have a 1:1 ratio, so currencies serve to facilitate transactions of goods and services. . In the crypto-economy, currencies exist before goods and services become widely available to customers. This makes cryptocurrencies difficult to value and unstable.
An economy must have enough goods and services to create enough supply and demand for consumers to use currencies to exchange those goods and services. With only NFTs and DeFi financial products in today’s crypto ecosystem, it’s very difficult to lure the ordinary Joe or Jane into the economy because there simply isn’t much to consume.
A healthy and functioning banking system also relies on sufficient supply of liquidity from customer deposits and sufficient customer demand to borrow. With more digital goods and services, especially non-financial such as art, music, real estate, or gaming hardware in the metaverse, the banking system will be able to use them as collateral to provide a variety of secured loans. Similar to car loans or mortgages, consumers in the crypto world will be able to own these products by paying periodically in the future.
A reliable credit score system
In today’s crypto lending market, no credit check or credit scoring system is required for customers to borrow cryptocurrency. Indeed, the loan is over-collateralized with a strictly controlled loan-to-value (LTV) ratio. As soon as the LTV exceeds the liquidation LTV threshold, the collateral will be sold at a discount to recoup the loan. The value of the collateral is never fully utilized and there is always a significant reserve in case of sudden depreciation in the value of the collateral.
In traditional banking, customers have a credit score based on their past transactional behavior and financial situation, i.e. annual income, savings, loan repayments and investments. In the crypto lending market, this is almost impossible because wallets are created anonymously and anyone can create as many wallets as they want. This makes it very difficult to track transactional behaviors and difficult to build a credit score.
For the current structure to change, users must be incentivized to establish a good history of all wallet activity and be loyal to the wallet. There are scores such as the LUNAtic for Terra rankings to rank order engagements within a certain channel, but there doesn’t appear to be a credit-specific score to rank the financial status of order portfolio owners.
As more jobs are created in the crypto space and more people are paid in cryptocurrency, wallets that show a long healthy track record of activities such as consistent inflow income , a continuous stable balance or regular repayments of a crypto loan, should be rewarded. The reward could come in the form of access to larger loans with lower interest rates; or have access to longer-term loans; or even in the form of airdrops of governance tokens.
A strong credit score system would benefit both the lender and the borrower. Lenders can earn more fees with lower risk by granting more loans to reputable borrowers; borrowers can access lower rates, longer term loans and other potential rewards. More importantly, a credit scoring system could help form a more transparent and healthy crypto lending market and attract more consumers to the ecosystem.
An actively managed collateral valuation system
Given the highly volatile nature of cryptocurrencies (at least for now), the value of the collateral needs to be assessed much more frequently than in a traditional secured loan. Unlike traditional collateral such as cars or homes whose values are more predictable and do not change dramatically over a short period of time, collateral in the crypto world such as NFTs or cryptocurrencies could suffer sudden bearish movements in a single day. Therefore, it is essential that lending platforms have robust collateral valuation systems capable of estimating the market value of any asset at any time.
It is not difficult to assess the market value of NFTs or cryptocurrencies minute by minute. But as more and more goods and services become available in the crypto ecosystem and more and more types of assets become eligible as collateral, having a high-performance collateral valuation system frequency can be expensive.
Alternatively, lending platforms can create something similar to the concept of risk-weighted assets (RWA) in the banking world to give more risk weights (lower liquidation LTV thresholds) to riskier collateral and less to more secure collateral so that they don’t necessarily need to have a high-frequency collateral evaluation system.
For example, blue chip NFTs such as the Bored Ape Yacht Club (BAYC) may be assigned a higher liquidation LTV threshold and be assessed less frequently. As historical NFT prices become available, more data points can be collected and used to derive a more accurate risk weight metric.
As more and more goods and services become available in the crypto-economy, a reliable credit scoring system and an actively managed collateral assessment system will allow the crypto-banking infrastructure to provide more funding options other than token-backed loans.
The future prospects of crypto-finance depend on the types of goods and services available to the crypto-economy and can only compete with the scale of traditional banks when the crypto-economy transforms into a more diverse market space. and more attractive to more consumers.
The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph.com. Every investment and trading move involves risk, you should conduct your own research when making a decision.