Transitioning to a tech-driven, non-custodial economy is neither easy nor seamless. But DeFi and the diverse solutions it enables are making this possible. The metaverse is catalyzing this drive manifold. Together, these two booming industries disrupt traditional economies, innovating inclusive digital systems for asset ownership and value transfer.
DeFi innovators, for one, have explored nearly every existing industry for potential use cases. Besides solving specific problems, these usually tend to transform legacy systems comprehensively. The ultimate goal is to establish community-oriented and user-centric financial systems with rich utility and wide access.
One such domain where decentralized technologies are making significant headway is lending and borrowing. DeFi is completely overhauling the ways in which we experience loans and interests, introducing novel opportunities in the process.
Yet, certain issues remain. Overcollateralization is primary among them. Fortunately, though, we are witnessing the rise of actual solutions that leverage undercollateralized loans as a leeway to the future.
Towards Trustless Lending-Borrowing
We have been lending and borrowing, in one form or another, almost since the dawn of civilization. The processes have evolved significantly over time, becoming increasingly complex and multifaceted. But one key element has remained constant through such changes. It’s trust, which is pretty much been the foundation of all lending-borrowing transactions.
Trust is generally considered good, which has its merits. We must somewhat trust each other to function as social beings. But putting trust as the basis of financial processes often has negative consequences. Particularly in institutional scenarios, where multiple people with conflicting interests are involved, trust is often misused and manipulated for corruption. Excessive dependence upon trusted intermediaries—banks and brokers, for example—also leads to higher costs, performance bottlenecks, and security lapses.
DeFi thus promotes trustlessness. It leverages permissionless blockchains and smart contracts to automate lending-borrowing, minimizing the need for intermediaries. DeFi protocols embed trust in code and algorithms, rather than vesting authority in the top management. And because the codebase is usually open-source, these protocols ensure transparency regarding the custody and utilization of funds. The risk of corruption is also minimal. Transactions are secure, even when the counterparties cannot trust each other.
From Trust to Access: Broadening DeFi’s Practical Relevance
So much for how DeFi rethinks the role of trust in lending-borrowing. But it’s no good unless it ensures practical benefits for individuals and enterprises. Accessibility is thus extremely vital.
Overcollateralization is a significant corollary of the trust issues in legacy lending-borrowing. Because lenders lack robust means of securing repayments or retrieving bad loans, they require borrowers to deposit collateral whose value is greater than the loan amount. To borrow, say, $10, one needs to deposit collateral worth $50.
This raises the entry barriers too high, making lending-borrowing an exclusive domain overall. Only those with access to substantial capital upfront can borrow money at reasonable rates. Whereas those who do not have such capital find their last resort in informal sources, ultimately paying outrageous interests. And the global unbanked and underbanked population is, naturally, the worst hit in this scenario.
If DeFi lending-borrowing is to become practically relevant for the mainstream, it must necessarily provide a level playing field for the underdogs. It can’t become merely a marketplace for the ultra-rich, which has been a persistent problem with traditional finance. Championing undercollateralized and trustless loans is critical to this mission.
But although trustlessness is already commonplace in DeFi, undercollateralization isn’t. Only a few innovative projects—Paxo Finance, for example—are making the much-needed leap from automating trust to widening access. However, this shift of focus is extremely important, insofar as the latter translates directly to mass adoption. DeFi lending-borrowing should be open to all, closed to none.
Undercollateralization: The Leeway to Accessible Lending-Borrowing
What good is undercollateralization anyway? Doesn’t it jeopardize the security of lending-borrowing systems? How can lenders be sure of getting their money back if the borrower falters? These concerns are understandable but not justified in the context of DeFi. One may review the technicalities of protocols like Paxo to understand this in-depth.
Undercollateralized loans are important because they make lending-borrowing more accessible and profitable. It makes the first instance of getting a loan easier due to affordable collateral requirements. But the positive impact extends way beyond this point. The benefit entails more than some individuals gaining immediate access to liquidity for their needs.
By making borrowing feasible, undercollateralized loans unlock better opportunities for lenders to generate passive income without selling their assets. And since lenders have stronger incentives to lend, there’s deeper liquidity in crypto markets, which in turn boosts transaction volumes. It’s also possible to catalyze this process by leveraging cross-chain infrastructure to further enhance interoperability and capital efficiency. We thus establish a positive feedback loop with mass adoption as the ultimate outcome.
The Metaverse & DeFi Lending’s Next Evolutionary Phase
Adoption is desirable but only when there’s a simultaneous growth in terms of utility. It’s pointless to attract lenders and borrowers to crypto simply based on hype. For one, this won’t be sustainable in the long run. And these are the reasons making the rise of metaverses so significant for DeFi. It ensures a tremendous scope for diversification, particularly for undercollateralized lending-borrowing.
It’s already possible to lend and borrow assets other than ordinary cryptocurrencies, thanks to crypto-derivatives and NFTs. The metaverse adds more novel opportunities into the mix—the unthinkable is now thinkable.
From gaming to fashion, there’s a growing market for lending and borrowing all kinds of assets. Be it an in-game racing car or a phygitized luxury watch, whatever is ownable is also borrowable. We commonly refer to the sum total of these metaverse-based economies as MetaFi. And quite clearly, undercollateralization will be a boon in this domain.
Everything that makes undercollateralized loans promising in general also applies to MetaFi. Plus, there’s a wider scope, which makes it even better. Because when it comes to financial inclusion and accessibility, can we settle for anything but the maximum?
About the author:
Pranjal Prashar is a serial entrepreneur with hands-on experience in scaling tech startups from ideation to exit. Over the last 10 years, Pranjal has built & scaled 3 tech companies across Asia, Europe & US. Pranjal is a Co-founder of Paxo Finance, a protocol working to allow borrowers to take loans up to five times their equity.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.