Why will private credit usher in the next stablecoin cycle?

Source: X, @doganeth_en

Written by: Dogan

Compiled by: Shaw Jinse Finance

Low-collateralized credit will lead the next stablecoin cycle for several reasons.

Stablecoins are in a bull market: they help brick-and-mortar businesses move money quickly, at low cost, and securely. The foundation of this borderless payment is built on cryptocurrencies, while regulatory clarity such as the Genius Act and MiCA Act have led to breakthroughs by leaps and bounds. Today, large institutions are joining, either building their own stablecoins or joining existing stablecoin networks.

But this is just the beginning. We will usher in a second wave of popularization, when low-collateralization credit will appear. In this article, I’ll explain why we think low-collateralized stablecoin credit will be the next big trend.

Current on-chain lending

Currently, we already have an on-chain lending industry with a total value locked of nearly $(TVL) 50 billion and $25 billion in active loans. These protocols are very simple to operate:

Lenders deposit stablecoins;

The borrower secures the loan against other current assets.

However, the address market (TAM) of existing lending protocols is relatively small compared to the traditional financial sector. The assumptions of these protocols are:

Users own on-chain assets that are liquid and accepted by lending protocols;

Users can accept floating interest rates;

Users are willing to use cryptocurrencies (either for leveraged trading or for actual payments (which is not common)).

Today, stablecoin lenders typically pay higher interest than the real interest rate in the dollar because the supply of on-chain stablecoins is still small relative to demand. But where does this demand come from?

Leverage seekers: People love leverage, which is one of the reasons why “Perps” are emerging in the cryptocurrency space. They often lend against their assets in an attempt to expand their income and positions. They also use leverage to increase yields.

People who don’t want to sell assets but need to spend: Some people just want to keep their assets and don’t want to sell them, but they need funds to cover their expenses. Although this group of people is relatively small, it is very important.

Now everyone is happy, leverage seekers pay high interest to suppliers, and suppliers earn more than interest rates. But will this continue when stablecoins accelerate?

The golden age of stablecoins

Citigroup recently published an article predicting total stablecoin issuance: a base scenario of $1.9 trillion (previously predicted $1.6 trillion) and an optimistic scenario of $4 trillion (previously forecast of $3.7 trillion). They believe that there will be trillions of stablecoins on-chain by then. Therefore, there will be a large number of stablecoins idle in the future, and it is not difficult to foresee that the cost of mortgages will be significantly reduced. But in the current context, is there enough yield to cover the high interest on such a large stablecoin supply? The answer is no.

This is where low-collateralization credit comes into the market. Because mortgages are secure and relatively low-risk (the risk of bad debt is almost zero if the protocol runs procedurally), many stablecoin holders will be willing to extend credit to riskier groups: loans are based on factors such as credit score, future cash flow, asset holdings, etc. This is very different from our current on-chain lending market, and the risk is higher. Even if the loan interest rate is only 20% of the actual interest rate, it will still be a completely new and large market. So, how do we achieve this?

Low-collateralization credit market

In the past, many protocols have experimented with low-collateralized credit; They mostly give credit to market makers and investors and think they will pay it back. But unfortunately, as the examples of TrueFi, Goldfinch and Maple Finance show, these protocols can go bankrupt and never pay their debts. The reason is: the borrower took on too high a risk and obtained credit that was not available in other markets; The main problem is that they use too much leverage and high-risk investments. In addition, some protocols focus on providing low-collateralized credit to retail users, but they also fail because crypto retail investors have a bad habit of taking advantage of a loophole (even if it’s just $1), and they think it’s their right. We’ve seen this in rewards programs, affiliate marketing, and more. Therefore, there should be effective ways to prompt people to pay their debts. So, what forces people to pay their debts?

1. Cut ties to the product: Agreements can start with a small amount (e.g., $10, $50, or $100) and use zkTLS-like methods to ensure they can afford to repay. If they don’t repay, the agreement can ban them and never release any debts again. It sounds reasonable, but I’m sure there will always be people who use their family status to exploit loopholes in the system and never pay back.

Pros: The system can easily provide credit services to people around the world without geographical restrictions. Therefore, its construction is relatively easy and is also allowed by current law.

Disadvantages: The system is likely to eventually go bankrupt, generating a large number of unrecoverable bad debts. And this system can only start with a small amount of money, so high-net-worth individuals will never use it.

2. On-chain debt auctions: We can first ensure that borrowers have funds, credit scores, and/or future cash flows; Then, if the borrower defaults, the debt collection agency buys the debt from the agreement through an on-chain auction. For this mechanism to work effectively, debt collection agencies must be able to carry out the necessary legal procedures and force borrowers to repay their debts. The system can be easily scaled to large players, including high-net-worth individuals, medium-sized borrowers, and even crypto gamblers.

Pros: The system makes it easy to ensure that people pay their debts because it affects their lives (I don’t approve of this, but there is no other way in the capitalist world) and it is easy to find credit applicants who need a lot of money.

Cons: This means they are unlikely to expand to all markets. They may start in small markets and then exploit regulatory loopholes in credit creation. And in some areas, this system may require expensive license fees.

I don’t think there is one solution that works in all cases. But it’s really a good option to consider; I feel like this is an effective way to enter the market and gain market recognition.

What happens next?

The supply of stablecoins is growing, and over the past four years, it has grown much faster than the entire cryptocurrency market. Therefore, it is a foregone conclusion that stablecoin yields will decline in the next few years. As a result, cryptocurrencies will increasingly become a channel for businesses to obtain low-cost credit. But given the nature of cryptocurrencies, the system cannot operate entirely permissionless because this low-collateralized credit system is not built on cryptocurrencies. We need more on-chain verifiable credentials, and private credit projects must find mechanisms to legally issue credit and enforce debt repayment if borrowers default.

Implementing this model globally is extremely difficult and will inevitably break some of the seamless on-chain composability we currently have. However, I think the emergence of a lot of free stablecoin liquidity will give rise to some obvious scenarios: companies will use cryptocurrency channels simply to earn additional income on top of Treasury bonds.