Author: equilibrium

Translation: Shan Oppa, Golden Finance

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

Despite the immense potential of on-chain lending, the current primary user base remains crypto-native users, with most use cases limited to speculative trading. This significantly restricts the total addressable market (TAM) it can cover.

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

Current State of On-Chain Lending

In just a few years, the on-chain lending market has evolved from a conceptual stage to multiple market-tested protocols, undergoing several periods of extreme market volatility without generating bad debts. To date, these protocols have attracted $43.7 billion in deposits and issued $18.6 billion in outstanding loans.

Source: DefiLlama

Source: Artemis

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

• Speculative Trading: Crypto investors use leverage to purchase more crypto assets (e.g., borrowing USDC against BTC collateral to buy more BTC, potentially cycling multiple times to increase leverage).
• Liquidity Acquisition: Investors obtain liquidity for crypto assets through borrowing without selling assets, thus avoiding capital gains tax (depending on the jurisdiction).
• Arbitrage Flash Loans: A very short-term loan (borrowed and repaid within the same block) used by arbitrage traders to exploit temporary price imbalances in the market and correct prices.

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

Compared to the global total of $320 trillion in outstanding debt or $120 trillion in loans to households and non-financial businesses, the current $18.6 billion in outstanding loans from on-chain lending protocols represents a negligible portion.

Source: International Finance Association Global Debt Monitor

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

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 limited number of crypto assets can be used as collateral, which greatly restricts the number of potential borrowers. Additionally, to compensate for the high volatility of crypto assets, existing on-chain lending typically requires collateralization rates 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 provided by the borrower must exceed the loan amount). This model leads to inefficient capital utilization, making many practical application scenarios (such as small business financing) difficult to achieve.

By adopting ultra-low collateral lending, on-chain lending can cover a broader borrower demographic, further enhancing its practicality.

The difficulty of implementing the above improvements varies; some are relatively easy to execute, while others may introduce new challenges. However, the optimization process can progress from easier to more difficult tasks.

Additionally, fixed-rate lending is also an important feature in the development of on-chain lending, but this issue can be addressed by having third parties assume the interest rate risk of borrowers (e.g., through interest rate swaps or customized agreements between lenders and borrowers), so this article will not discuss it in detail (there are already protocols, such as Notional, that provide fixed-rate lending services).

1. Expand the Range of Collateral Assets

Compared to other global asset classes, such as the public equity market ($124 trillion), fixed income market ($140 trillion), and real estate market ($380 trillion), the total market capitalization of cryptocurrencies is only $3 trillion, representing a small fraction of global financial assets. Therefore, limiting collateral to a subset of crypto assets significantly restricts the growth of on-chain lending, especially when collateral requirements are as high as 200% or more to compensate for the high volatility of crypto assets.

Tokenizing assets in conjunction with on-chain lending allows investors to utilize their entire portfolio for lending more effectively, rather than being limited to a small portion of crypto assets, thereby broadening the potential borrower base.

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

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

Ultimately, on-chain lending may evolve to the extent of allowing mortgage loans secured by real estate, where loan issuance, property purchase, and the deposit of the property into the lending protocol as collateral can be completed atomically within a single block. Similarly, businesses could also finance through lending protocols, such as purchasing factory equipment and simultaneously depositing it as collateral into the protocol.

2. Promote Low-Collateral Lending

Currently, most on-chain lending protocols adopt an over-collateralization model, where the value of collateral provided by the borrower must exceed the loan amount. While this model ensures lender security, it also leads to inefficient capital utilization, making many practical application scenarios (such as small business working capital loans) difficult to achieve.

In the crypto 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 centralized lending platforms (such as BlockFi, Genesis, Celsius). However, early decentralized low-collateral lending attempts (such as Goldfinch and Maple) mostly processed lending logic off-chain or ultimately shifted to an over-collateralization model.

A noteworthy new project is Wildcat Finance, which attempts to reintroduce low-collateral lending while retaining more on-chain components. Wildcat acts solely as a matching engine between borrowers and lenders, allowing lenders to assess the credit risk of borrowers themselves rather than relying on off-chain credit assessment processes.

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

The greatest growth opportunity for on-chain lending products lies in markets that traditional banks cannot effectively cover, such as:

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

2. Small Business Financing: Due to the smaller loan amounts, large banks are often reluctant 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 Address

While 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. Managing Debt Positions Backed by Illiquid Assets

Crypto assets trade 24/7, while other highly liquid assets (such as stocks and bonds) typically trade Monday through Friday, but the price update frequency of illiquid assets (such as real estate and artwork) is far lower. The irregularity of price updates complicates the management of debt positions, especially during periods of extreme market volatility.

2. Liquidation Issues of Physical Collateral Assets

While ownership of physical assets can be mapped to the blockchain through tokenization, the liquidation process is far more complex than that of on-chain assets. For example, in the case of tokenized real estate, the asset owner may refuse to vacate the property, and legal proceedings may be required to enforce liquidation.

Given that on-chain lending protocols (and 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 would be responsible for handling the liquidation affairs. Such mechanisms need to be deeply integrated with real-world legal systems to ensure the feasibility of asset monetization.

3. Determining Risk Premiums

Default risk is a part of lending operations, but this risk should be reflected in the risk premium (i.e., an additional rate added to the risk-free rate). Particularly in the low-collateral loan sector, accurately assessing the default risk of borrowers is crucial.

There are currently various tools available for estimating default risk, depending on the type of 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 sheets, and other financial conditions on-chain. In the future, if financial data is fully on-chain, corporate financial information could be seamlessly integrated with lending protocols or third-party credit rating services to assess credit risk in a more trustless manner.

4. Decentralized Credit Risk Models

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 presents two major problems: new entrants find it difficult to compete because they cannot access equally sized datasets. Decentralizing data processing is challenging because credit assessment models cannot be controlled by a single entity, and user data must remain private.

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

Other challenges include on-chain privacy, adjusting risk parameters as the collateral pool expands, regulatory compliance, and facilitating the use of borrowed proceeds for real-world utility.

Conclusion

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

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

Ultimately, on-chain lending will help eliminate financial inequality, allowing all businesses and individuals, regardless of their location, to access capital equally. As Theia Research summarized: "Our goal is to build a financial system where net interest margins are compressed to the cost of capital."

This is a goal worth striving for!

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