Avoiding DeF…ault

Gm, everyone. What do Celsius depositors and your great grandparents have in common? They’ve both gone to a bank and not been able to withdraw their money. Turns out some of the bad lending practices that punctuated the last bull run aren’t so original after all.

It begs the question: Could DeFi protocols be subject to the same kind of crises that have hit traditional finance throughout history? Today, let’s consider what recent moves in the DeFi sector say about the future stability of the industry.

—Vincent

DeFi Lenders Go Where CeFi Failed to Tread

Years before Celsius went bankrupt, former CEO Alex Mashinsky told users that the lender’s entire loan book was overcollateralized. The issue with this assurance? Mostly that it was false.

Celsius admitted to CoinDesk that it was extending unsecured loans to institutional clients. The lender was also rehypothecating collateral, which is a practice in which the collateral on one loan becomes a line of credit itself to another borrower. To top it off, Celsius was also investing depositor funds into DeFi protocols to generate higher yields for its depositors.

Put that in context: “If you go to your bank and deposit $100, you expect to be able to withdraw your $100 at any point, right? You expect your bank to be managing that $100 responsibly,” pseudonymous crypto researcher Crypto Joe told CoinDesk. “If you go to your bank and the bank says, ‘Sorry, we invested it in low-cap sh*tcoins, and you now no longer have $100,’ you’d be pretty upset, right?”

But when Celsius and Voyager Digital went bankrupt in this latest crash, crypto users pointed out that the root of their issues was centralization. DeFi lending protocols like Aave and Compound—with all of their processes automated and untouched by human error—were unaffected. So while DeFi is susceptible to massive hacks, at least it won’t be susceptible to the hubris of and greed of human beings, or so the logic goes.

But…there’s a but: Some big players within the DeFi lending market are taking on new financial risks by pushing out loans that have no collateral or less than 100% collateral.

Most DeFi lending is still overcollateralized, though, right? Yes, it is. According to The DeFiant, DeFi protocols have lent out $10 billion in loans that are fully backed by some sort of collateral in case the loans go bad. Several protocols, however, carry about $160 million of outstanding loans that aren’t backed by any collateral.

While unsecured lending is an industry that’s much smaller and more fragmented than collateralized lending, it’s certainly heating up. Ribbon’s unsecured lending product, Lend, launched in October and allows users to extend unsecured loans to the institutional market makers of their choosing.

Julian Koh, the CEO of Ribbon, told CoinDesk that “[u]sers are willing to move out the risk curve if the risk-reward makes sense.” Which is finance speak for “people will take more risks with their money if we offer them a higher reward.”

• FYI: Because the loans Ribbon offers are unsecured, Ribbon is able to charge firms like Folkvang Trading and market maker Wintermute some 9% on USDC loans versus the .5% that Aave or Compound would charge them.

• For its part, Ribbon is offering these loans in a manner that’s closer to traditional banking with underwriting taking place first. Credora does creditworthiness checks for Ribbon.

Another example: A new DeFi lending protocol called DeltaPrime will offer loans that only require 20% collateral when it launches next month.

DeltaPrime claims that it can offer loans like this and remain solvent because the loan is locked up in a smart contract that acts like a brokerage. The smart contract then forces users to only use the funds of the loan in protocols that DeltaPrime approves of. This model assumes, however, that DeltaPrime will be able to accurately assess the financial stability of the protocols it whitelists for users.

The big picture: Crypto companies and protocols have long taken issue with traditional bank credit ratings, underwriting, and know-your-customer regulation. There is also a subset of the industry that is of the mind that fractional reserve banking—extending loans without collateral—is akin to a Ponzi scheme (traditional finance theorists and economists don’t align with this).

At the same time, the crypto community understands that there is an appetite for loans that don’t lock up large amounts of crypto that could be used in trading. But in offering these loans without either collateral or traditional underwriting checks, the community subjects protocols to more human error and future systemic risks.

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And that’s what you need on your radar today. What lending protocols do you use? Reply to this email and let us know. See you Tuesday!