The Future of On-chain Lending: From Speculation to Practicality

On-chain lending protocols serve as the cornerstone of Internet finance, with a vision to provide fair access to capital for individuals and businesses worldwide. This model helps establish a more equitable and efficient capital market, thereby driving economic growth.

Although the potential for on-chain lending is enormous, the current main user base still consists of crypto-native users, and its use is mostly limited to speculative trading. This greatly restricts the total market it can cover.

This article will explore how to gradually expand the user base and transition to more productive lending scenarios while addressing potential challenges.

The Current Situation of On-chain Lending

In recent years, the on-chain lending market has rapidly evolved from the conceptual stage into multiple market-tested protocols, undergoing several severe market fluctuations without resulting in bad debts. As of now, these protocols have collectively attracted $43.7 billion in deposits and issued $18.6 billion in outstanding loans.

Currently, the main sources of demand for on-chain lending protocols include:

• Speculative trading: Cryptocurrency investors use leverage to purchase more crypto assets.
• Liquidity Acquisition: Investors obtain liquidity for crypto assets through borrowing without having to sell the assets, thereby avoiding capital gains tax (depending on the jurisdiction).
• Arbitrage Flash Loan: A very short-term loan used by arbitrage traders to take advantage of temporary price imbalances in the market and make price corrections.

These applications primarily serve crypto-native users and are mainly speculative. However, the vision for on-chain lending goes far beyond this.

Compared to the global total of outstanding debt of 320 trillion dollars, or the total loans of households and non-financial enterprises of 120 trillion dollars, the current outstanding loans of 18.6 billion dollars from on-chain lending protocols account for only a negligible portion of that.

As on-chain lending gradually shifts towards more productive capital uses (such as small business financing, personal car purchases, or mortgage loans), its market size is expected to grow by several orders of magnitude.

The Future of On-Chain Lending

To enhance the practicality of on-chain lending, two key improvements are needed:

1. Expand the range of collateral assets

Currently, only a few crypto assets are available as collateral, which greatly limits the number of potential borrowers. In addition, to compensate for the high volatility of crypto assets, existing on-chain lending typically requires collateralization ratios of up to 200% or higher, further suppressing lending demand.

Expanding the range of acceptable collateral assets can not only attract more investors to use their portfolios for lending but also enhance the lending capacity of on-chain lending protocols.

2. Promote ultra-low collateral lending

Currently, most on-chain lending protocols adopt an over-collateralization model (i.e., the value of collateral assets that borrowers must provide exceeds the loan amount). This model results in low capital utilization efficiency, making it difficult to achieve many practical application scenarios (such as small business financing).

By adopting ultra-low collateral lending, on-chain lending can cover a wider range of borrowers, further enhancing its practicality.

The implementation difficulty of these improvement measures varies, with some being relatively easy to implement, while others will pose new challenges. However, the optimization process can be advanced step by step, from easy to difficult.

Expand Collateral Asset Scope

Compared to other asset classes globally, the total market capitalization of the cryptocurrency market is only $3 trillion, accounting for just a small portion of global financial assets. Therefore, limiting the range of collateral to certain crypto assets significantly restricts the growth of on-chain lending, especially when collateral requirements are as high as 2 times or more to compensate for the high volatility of crypto assets.

Combining asset tokenization with on-chain lending enables investors to more effectively leverage their entire investment portfolio for borrowing, rather than being limited to a small portion of cryptocurrency assets, thereby broadening the potential borrower base.

The first step in expanding the range of collateral assets may start with highly liquid and frequently traded assets (such as stocks, money market funds, bonds, etc.), as these assets have a minor impact on existing lending protocols and entail lower modification costs. However, the speed of regulatory approvals will become a major limiting factor for growth in this area.

In the long term, expanding into physical assets with lower liquidity (such as tokenized real estate ownership) will offer tremendous growth potential but will also bring new challenges, such as how to effectively manage the debt positions of these assets.

Ultimately, on-chain lending may evolve to the extent of using mortgaged properties for loans, meaning that the issuance of loans, the purchase of properties, and the deposit of properties into lending agreements as collateral can be atomically completed within a single block. Similarly, businesses can also finance through lending agreements, such as purchasing factory equipment and simultaneously depositing it as collateral into the agreement.

Promote Low-Collateral Lending

Currently, most on-chain lending protocols adopt an over-collateralization model, meaning that borrowers must provide collateral assets worth more than the loan amount. While this model ensures the safety of lenders, it also leads to inefficient capital utilization, making it difficult to realize many practical application scenarios (such as working capital loans for small businesses).

In the cryptocurrency industry, the initial demand for low-collateral lending may come from market makers and other crypto-native institutions that still need financing channels after the collapse of some centralized lending platforms. However, early attempts at decentralized low-collateral lending mostly handled the lending logic off-chain or ultimately turned to an over-collateralization model.

Outside the cryptocurrency industry, low-collateral lending has been widely applied in personal loans (such as credit card debt, buy now pay later) and business lending (such as working capital loans, microloans, trade financing, and corporate credit lines).

The biggest growth opportunities for on-chain lending products are in markets that traditional banks cannot effectively cover, such as:

1. Personal Lending Market: In recent years, non-traditional lending institutions have been steadily increasing their share in the personal low-value mortgage market, especially among low-income and middle-income groups. On-chain lending can serve as a natural extension of this trend, offering consumers more competitive loan rates.

2. Small Business Financing: Due to the smaller loan amounts, large banks are often unwilling to lend to small businesses, whether for business expansion or working capital. On-chain lending can fill this gap, providing a more convenient and efficient financing channel.

Challenges to be Addressed

Although the above two improvements will significantly expand the potential user base for on-chain lending and support more efficient financial applications, they also introduce a series of new challenges, including:

1. Handle debt positions backed by non-liquid assets

Cryptocurrency assets are traded 24/7, while other highly liquid assets (such as stocks and bonds) are typically traded from Monday to Friday. However, the price update frequency of illiquid assets (such as real estate and art) is much lower than this. The irregularity of price updates can make the management of debt positions more complex, especially during periods of significant market volatility.

2. The liquidation issue of physical collateral assets

Although the ownership of physical assets can be mapped on-chain through tokenization, the settlement process is much more complex than that of on-chain assets. For example, in the scenario of tokenized real estate, the asset owner may refuse to vacate the property and may even require legal proceedings to carry out the settlement.

Given that on-chain lending protocols (as well as individual lenders) cannot directly handle the liquidation process, one solution is to sell the liquidation rights at a discount to local debt collection agencies, which will be responsible for handling the liquidation affairs. Such mechanisms need to be deeply integrated with the real-world legal system to ensure the feasibility of asset realization.

3. Determination of Risk Premium

Default risk is a part of lending operations, but this risk should be reflected in the risk premium (that is, the additional rate added on top of the risk-free interest rate). Especially in the area of low-value mortgages, accurately assessing the default risk of borrowers is crucial.

Currently, there are various tools available to estimate default risk, depending on the category of the borrower:

• Individual borrowers: Web proofs, zero-knowledge proofs (ZKP), and decentralized identity protocols (DID) can help individuals prove their credit scores, income status, employment situation, etc., while protecting their privacy.

• Corporate borrowers: By integrating mainstream accounting software and audited financial reports, companies can prove their cash flow, balance sheet, and other financial conditions on-chain. In the future, if financial data is fully on-chain, corporate financial information can be seamlessly integrated with lending agreements or third-party credit rating services to assess credit risk in a more trustless manner.

4. Decentralized Credit Risk Model

Traditional banks rely on internal user data and external public data to train credit risk models to assess the default probability of borrowers. However, this data silo effect brings two major problems: new entrants find it difficult to compete because they cannot access data sets of equal scale. The decentralized processing of data is more challenging because credit assessment models cannot be controlled by a single entity, while user data must remain private.

Fortunately, the fields of decentralized training and privacy computing are rapidly developing. Future decentralized protocols are expected to utilize these technologies to train credit risk models and perform inference calculations in a privacy-preserving manner, thereby achieving a fairer and more efficient credit assessment system on-chain.

Other challenges include on-chain privacy, adjusting risk parameters as the collateral pool expands, regulatory compliance, and making it easier to use borrowed yields for real-world utility.

Conclusion

In the past few years, on-chain lending protocols have laid a solid foundation, but they have yet to truly realize their full potential.

The next phase of on-chain lending will be even more exciting: protocols will gradually transition from scenarios dominated by crypto-native and speculative activities to more efficient and real-world financial applications.

Ultimately, on-chain lending will help eliminate financial inequality, allowing all businesses and individuals, regardless of their location, to access capital equally. Our goal is to establish a financial system where the net interest margin is compressed to the cost of capital.

This will be a goal worth striving for!