UTU’s trust recommendation engine and credit trust oracles can help solve many of the problems with DeFi loans.
Decentralized finance, or DeFi, has seen immense growth over the past couple of years. DeFi has democratized access to financial products and services that only traditional players like banks and mortgage lenders have provided in the past. While there are many benefits to DeFi, the sector certainly still has its problems.
UTU is building trust infrastructure for the entire internet and we can help solve many of the problems that both DeFi products and their users face with respect to collateral, credit scoring, and more.
In this post, we’ll cover what DeFi is (focusing specifically on DeFi loans), how they improve upon traditional loans, what problems exist, and how UTU helps address these issues.
What are DeFi loans?
DeFi is a new sector of products that demonstrates the transformative power of blockchain technology. DeFi is a distributed finance approach where individuals can access financial products and services such as loans, trading, synthetic assets, and more without a central authority such as a traditional bank.
You have to jump through many hoops to access a traditional loan. Here are the steps that may be involved:
- Engage with an employee of your local bank or mortgage provider.
- Then fill out a bunch of paperwork and provide your lender with proof of collateral.
- The lender will then have to verify that you’re really you, run credit and background checks, properly value your collateral, and complete a bunch of other administrative tasks.
- If all this checks out, only then will you receive your loan.
On the other hand, DeFi has allowed anyone to get a loan quickly and easily.
All you need to do is provide collateral in the form of cryptocurrency (such as ETH, WBTC, and others) to a DeFi lending platform like Maker, Compound, or Aave, and voila — you are granted a cryptocurrency loan instantly.
DeFi products run on smart contracts, which is software code that manages how the funds are received and distributed. The details of the loan — such as the amount of collateral needed, what the interest rate is, who manages escrow, and more — are programmed into these smart contracts so that no middleman is necessary to approve or deny loans.
Bloqboard’s head of growth, Nick Cannon, told Cointelegraph about the benefits of DeFi:
“The main advantages are the control, security and permissionless nature offered for the end users by DeFi products. Permissionless because everyone can access it without conditions and independent of your local financial system’s health. Security and control because the vast majority of DeFi products are non-custodial and offer the option to opt-out of their service with a simple transaction.”
Let’s dig into these benefits a little more.
The Benefits of DeFi Loans
DeFi loans bring massive benefits above and beyond what traditional loans offer. Here are a few of them.
The most significant advantage of DeFi loans is speed.
Gone are the days of speaking with a lender, filling out loads of paperwork, and waiting weeks for approval. You can obtain a DeFi loan with a few clicks and within seconds as long as you provide enough collateral.
You don’t need to read several pages of terms and conditions to understand DeFi loans. The terms are clear, there isn’t much fine print, and DeFi loan platforms are relatively easy to navigate.
With traditional loans, you may have to understand the law. In DeFi, the code is the law. Smart contracts automatically implement the terms of the loans for all parties.
Equality and transparency
In many countries, the financial system is heavily biased against certain groups of people and unfairly restricts them from applying for or receiving financing. As a consequence, it may be impossible for the average citizen or entrepreneur to obtain a loan.
DeFi breaks through these barriers. There is no favoritism in the system and the smart contracts have no bias. DeFi transactions are decentralized and stored on a distributed public ledger, and anyone who meets the collateral requirements can access loans.
More control over your finances
The decentralization that blockchain provides allows you to have more control over your finances.
The original developer of Bitcoin, Satoshi Nakamoto, had a vision of a financial world that was free from centralized control. A decentralized, permissionless system ensures that everyone has the ability to control their own money.
With DeFi, you fully control how much you want to borrow and what you do with the loaned funds.
DeFi reduces fraud because the specific terms of the loan are programmed into the smart contracts.
The smart contract code evaluates the collateral and loans the money based on this collateral — nothing more and nothing less. The smart contract cannot be gamed or bribed to provide a better interest rate, larger loan amount, or any other more favorable terms. The terms of the DeFi loan are the terms that everyone gets.
The DeFi lending platform is also less susceptible to fraud. Fake collateral cannot be used and collateral valuations cannot be manipulated. This is not the case in traditional loans, where fake gold bars can be passed as collateral and home values can be artificially inflated to increase loan sizes.
Problems with DeFi loans
Though DeFi loans bring many benefits, there are still risks involved. The DeFi space is young and many problems are still being discovered and addressed. Here are some of the key issues with DeFi loans.
Smart contract risk
Smart contract risk — the risk that there may be a bug in the software code — is one of the biggest problems with DeFi.
There may be tens to hundreds of thousands of lines of code in DeFi applications, so there is certainly a risk that bugs in this smart contract code exist. These bugs may be exploited, which could lead to loss of funds and collateral. And because blockchains are immutable, these exploits can’t be reverted.
A great example of smart contract risk is YAM finance. The team discovered a bug that minted too much of their governance token YAM to reserves, which would prevent any future governance actions to take place. This led to the shutdown of the first version of the platform.
Liquidation risk is another problem that DeFi borrowers face.
The cryptocurrency market is very volatile, and a significant drop in price in a crypto asset might happen within a few minutes. If you use a crypto asset as collateral for a DeFi loan and the price of that asset drops significantly, you may be liquidated before you’re able to return the loaned funds.
For example, MakerDao requires you to deposit a crypto asset as collateral in the amount of 150% of the loan. So if you want to borrow 100 DAI from the platform, you must deposit $150 worth of ETH, LINK, or another crypto as collateral. If the price of the collateral drops below this 150% threshold, your collateral will be liquidated and you will have to pay a liquidation penalty on top of your lost funds.
The chart below (H/T to Natan Baredes) shows the relationship between the price of ETH and the 30-day average of collateral liquidated on the Maker platform. As you can see, when ETH price falls, liquidation amounts go up. Risky.
Oracles play a crucial role in DeFi lending platforms. For instance, in the previous MakerDao example, oracles feed the price of the crypto used as collateral into the system. If the oracle price data is inaccurate, loan collateral may be inadvertently liquidated. And if this happens on a widespread scale, the stability of the entire DeFi platform is at risk.
Ultimately, if you are not technically knowledgeable enough to understand how an oracle’s data feed works and its level of data accuracy, you will have to trust that the oracle provider is doing the right thing, or rely on a trusted third party to assure you of this.
Risk of being scammed
Many DeFi platforms are developed by anonymous teams with fake identities.
There have been many situations where anonymous developers have either completely run away with DeFi investors’ money or sold a large amount of the platform’s governance tokens, leaving other holders with worthless tokens.
While these anonymous developers aren’t always malicious, you must have significant trust in that they won’t scam you.
Borrower risk (taken on by DeFi platforms)
In the MakerDao example above, the 150% overcollateralization is necessary to ensure that they have enough collateral to back all the DAI that they lend. This is because they have no way to determine the creditworthiness of borrowers.
Is every loan recipient the same? Of course not. But Maker and other platforms treat everyone the same and forces you to provide a high amount of collateral, even if you are more creditworthy than others.
How UTU solves problems with DeFi loans
UTU’s trust infrastructure addresses many of the big problems that DeFi protocols and their users face. Our protocol incentivizes and rewards users who provide truthful endorsement data with UTU trust tokens, and all data is on-chain. This ensures that all endorsement and recommendation data is legitimate and can’t be compromised. To read more about our trust model, you can read our whitepaper.
Here’s how UTU can help increase trust and transparency of the DeFi sector in particular.
Recommendations for trustworthy DeFi protocols
With so many DeFi platforms available, it can be difficult for you to determine which ones are trustworthy. UTU’s trust layer can be applied to help you choose which DeFi protocols fit your unique requirements and that you want to interact with.
We recently launched the MVP (Minimum Viable Product) of our DeFi Portal as a first step in increasing the trust of DeFi. This portal analyzes your interactions with existing DeFi apps and identifies other addresses that you’ve interacted with, and their engagement with these DeFi apps. This essentially builds a trust graph based on your crypto network.
There’s much more to come with our DeFi Portal, so please stay tuned.
UTU’s credit trust oracles
We’ve also introduced new and unique ways to determine a DeFi borrower’s creditworthiness to increase the trust between DeFi platforms and its users.
UTU’s trust infrastructure accesses contextually relevant data to provide trusted creditworthiness assessments. Our models combine on-chain transaction data with off-chain data such as that from social graphs, mobile money transactions, and many other contextual factors, to come up with a credit trust score.
With this additional layer of trust, you may be able to borrow DeFi loans by providing lower collateral amounts, which lowers your liquidation risk.
Moreover, UTU’s recommendation engine can allow both lenders and borrowers to better assess the other party and therefore make more informed financial decisions. This will also allow lenders to lend on their own terms, rather than those pre-defined by existing platforms such as Compound.
UTU will make these mechanisms available via oracle feeds to allow upcoming DeFi lending protocols to 1) better identify potentially risky borrowers and 2) support under-collateralized loans, enabling access to trustworthy borrowers who may not be able to afford high amounts of collateral.
Recommendations for existing credit scoring oracles
There are a number of credit scoring oracles that exist. But which ones are trustworthy enough for DeFi protocols to support? And should DeFi app users be able to choose which ones should represent their creditworthiness?
Our trust layer can be applied to these credit scoring oracles to determine their trustworthiness. This will enable users to endorse credit scoring oracles as trustworthy or not, and other users and protocol builders can review such endorsements from users they trust.
Specifically, this system will enable peer-to-peer lending, where each lender can decide which oracles and borrowers they trust to which degree, and therefore what amount of collateral to require and what interest rate to charge. In other words, this establishes a fully decentralized P2P reputation mechanism for creditworthiness.
All of the endorsement data will live on-chain, so anyone can verify that our recommendations are truthful. This also ensures that we cannot fraudulently recommend our own oracles over others.
DeFi loan platforms provide many benefits over traditional lenders, which explains their explosive growth. But they certainly still have many problems that need to be addressed.
We believe in the huge potential of DeFi loans and other decentralized financial services, but think that this potential can only be achieved if trust barriers are overcome. So we’re building tools to help solve these issues of overcollateralization, trust of third-party oracles, and more.
To read more about how UTU is pioneering digital models of trust for DeFi and many other industries, click here.