Borrowing Without Collateral: How Crypto Can Finally Build Credit

By Rafael Cosman, Co-Founder & CEO of TrustToken

If you’ve been paying attention to the DeFi sector, you’ll have noticed the emergence of bold new “unsecured” lending protocols, or lending platforms with zero collateral requirements that serve to maximize capital efficiency for borrowers. Such methods of lending, if perfected by blockchain, have the potential to bring the $11-trillion credit industry on-chain.

In the beginning of finance, collateralization was used as a valuable insurance plan for lenders, by securing loans through assets in order to offset default risk. In DeFi, collateralized loans have served as the backbone of open lending protocols absent any viable alternatives. Because crypto protocols often aim to be fully trustless, they often require over-collateralization. 

For example, in many cases, loans on MakerDAO must be collateralized by 150% of the value of the borrowed assets. This gives MakerDAO strong protection in the event of a default.

A proliferation of locked-up collateral holds back the potential of the market because it ties up otherwise-useful capital in order to manage counterparty risk. Collateral trapped on a large scale can severely impact the economy, as was the case with insurance-linked securities after Hurricane Irma in 2017. 

By overhauling and reducing collateral requirements, the system not only becomes more attractive overall for borrowers, but it can alleviate a significant amount of capital from being locked up unproductively. When borrowers have more access to funds that can be invested into the system, the market is more active and able to grow.

For the lending ecosystem to mature, the one thing most experts actually agree on is the need to overcome the issue of over-collateralization. And as DeFi continues on its impressive trajectory, the almost limitless versatility of the Ethereum protocol has enabled innovative new alternatives to collateralized lending. 

The uncollateralized era

Uncollateralized lending represents a significant shift for lending, which until now has been focused on only one of the traditional “five Cs” of credit led by collateral. While flash loans - that is, ultra short-term uncollateralized loans, often out for only seconds or minutes at a time - have certainly caught the crypto-limelight, uncollateralized lending is increasingly harnessing dynamic answers to the loan approval conundrum. Industry observers initially remained hopeful but skeptical on how on-chain lending could truly maintain integrity without collateral, yet the continued growth of uncollateralized protocols in 2021 has begun to convince doubters.

The first partial step towards uncollateralized lending was Aave’s credit delegation product, which allows one user to “delegate” their collateral to another, and a borrower to loan out more than their collateral would normally cover. This format is effectively semi-collateralized, because the borrower uses someone else’s collateral to take out the loan. But on the side of the protocol, the loan is still essentially over-collateralized, because if the borrower defaults, the full collateral is at risk of liquidation.

What's now taking form is a series of emerging unsecured protocols, many of which are mixing governance with a blend of on-chain and off-chain credit data. These models impose elements such as loan conditions and risk tolerance on each group of loans, while putting the power to vote on new borrowers and loans in the hands of token holders. 

Unsecured lending is constantly refining itself to improve its service and versatility in the lending ecosystem. Now, as new lines of business for unsecured lending in DeFi begin to take shape, future on-chain borrowers will qualify for a loan based on a composition of all five Cs: not just collateral or loan conditions, but also the character of the borrower (based on lending history), capacity based on the borrower’s debt-to-income ratio, and the amount of capital the borrower has on hand.

By establishing a group of approved stakers with a vested interest in the protocol’s success, uncollateralized lending protocols are engaging their community of users and token holders to determine the protocol’s risk appetite. Whether relying on expert delegates, a black box credit model, or the wisdom of the crowd, assessing the creditworthiness of borrowers and individual loans will be the kingmaker for the success of unsecured lending protocols moving forward. 

In case of default, providing true incentivization for a trusted group of high-quality stakers to approve loans wisely and stake accordingly will be a key ingredient to galvanize unsecured lending. Those protocols that possess a strong framework for enforcing action against delinquent loans will further accelerate the shift away from collateralized lending.

 “In retrospect, it was inevitable...”

When asked about Tesla's adoption of Bitcoin (before he backtracked), Elon Musk shared that “In retrospect, it was inevitable.” The same could be said for the dominance of unsecured lending. The writing has been on the wall for some time: Everything from college loans and hospital bills to deferred taxes and credit cards are now unsecured. 

The lending ecosystem has just needed the right technology, the right circumstances, and the right impetus for the inevitable unsecured lending revolution to finally materialize. Now that it has wind in its sails, collateral will slowly, but surely, become just one of many factors in the lending equation.

About Rafael Cosman

Rafael Cosman is the Co-Founder & CEO at TrustToken, makers of the TUSD and other TrueCurrencies, and TrueFi, the leading collateral-free lending protocol.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.