De-Fi Lending: Introduction

By Noah Carr and Grace C Zhou

The Banking Business Model

The Classic Framework for Saving & Lending

Banks have historically offered main services: deposit accounts where clients can safely store money and loans where applicants can apply to be given money for interest in return.

Once depositors put their money in the bank, the bank then pools this money and lends it out to the borrowers. Depositors receive interest for keeping their money at the bank, and borrowers pay interest to borrow money. The difference between these two interest rates becomes the bank’s earnings.

A Maturity Mismatch

A historic problem with the banking model has been that of asset and liability maturities. Most deposits put into the bank are considered short-term because the depositors can withdraw their money at any time, but borrowers are long-term because they take time to repay the bank (ex. 5, 10-year loans). Therefore, the banks have to moderate the discrepancy between short-term deposits and long-term loans to make sure there is enough money for depositors to withdraw their money.

How do the banks guarantee depositors their money in the bank is safe?

FDIC: Each bank account is insured by the government for up to $250K (in case of bank default).
Liquidity Coverage Ratio: banks are required to keep a certain amount in cash or reserves at the FED at all times based on outflow rates for depositors to withdraw at any point in time.

How do banks set interest rates?

The risks banks face in this include the aforementioned liquidity risk as well as credit default risk. Valuations for these risks are based on complex models. They then adjust the interest rate they charge to compensate for those risks appropriately.

The Marketplace Lending Model

What is Marketplace Lending?

A second option for borrowers is to turn to marketplace lending. Marketplace lending (sometimes. referred to as “peer-to-peer” or. “platform” lending) is a relatively new kind of online lending. Marketplace lending uses online “platforms” to connect consumers or businesses who seek to borrow money with investors willing to lend out (or invest in) a loan. In this case, the intermediary function is being performed by the respective platform instead of a bank.

In the event that a depositor does not trust the bank’s credit analysis, or a lender’s credit score is too low for a loan, marketplace lending offers the opportunity to directly choose the loan(s) one’s money gets invested in.

New Risk

As just stated above, in marketplace lending, savers, the marketplace “depositors”, can choose borrowers they lend money to. The marketplace lender (MPL) acts as an intermediary between the savers and borrowers. To accomplish this, the MPL usually uses algorithms to determine the creditworthiness of the borrowers and produce an interest rate based on the creditworthiness as a benchmark for saver giving loans.

However, unlike with banks, the money ‘deposited’ is not insured. Therefore, on account of the higher risk, borrowers pay significantly higher interest rates compared to a bank loan to borrow money. This interest rate is determined by the marketplace.

Intro to Investing

In both of the above examples, interest rates are determined primarily by the risk of a borrower. Why is risk so pivotal to the lending and investing process?

Consider two opportunities in which you can invest your money:

Opportunity A: you have a 50% chance of earning $1M, and a 50% chance of earning $1.2M. Therefore your expected return is $1.1M.
Opportunity B: you have a 50% chance of earning $0, and a 50% chance of earning $2.2M. Your expected return is also $1.1M

In both of these situations, the expected return is $1.1M. But Opportunity B is significantly riskier. Therefore, the expected return of Opportunity B should be higher to compensate for the risk of loss.

If Opportunity B had a 50% of generating $0 and a 50% of generating $3M, resulting in an expected return of $1.5M compared to A’s safer $1.1M, B may prove more compelling than A to some investors.

Risk

If you know that your initial $1M can only increase +$1M by taking on a certain level of risk, or the risk premium, you can then reasonably assume that taking on higher risk should correlate to higher returns.

However, if we plot total risk or 𝝈 (sigma, i.e. the standard deviation, measuring the volatility. This can be seen as a risk.) against returns, there would be a confounder in the relationship between risk and return. There are likely some investments that have high risk and low returns.

Why is this? This is because we are only plotting against 𝝈 or total risk.

Total risk is composed of both common and idiosyncratic risk.

Common Risk is a risk that cannot be diversified away and generally affects a whole industry/economy/market, such as natural disaster, a pandemic, inflation, etc.)

Idiosyncratic risk is risk that can be diversified away and usually only affects a specific company, such as factory failure, workers protest, bad governance etc.

We do not consider idiosyncratic risk because we can invest in a large number of investments to decrease our idiosyncratic risk of the whole portfolio. For example, a high return, the low-risk investment might actually have a lot of idiosyncratic risks and not a lot of common risks. If we add that one investment to several other investments with their own idiosyncratic risks, each idiosyncratic risk will have a lower impact on the portfolio. Therefore, if we take away idiosyncratic risk, we get a direct correlation between common risk and return.

So how do we plot the return? In order to plot a line, we use the equation Y = mx + b.

In this case:

Y = expected return
B = intercept of an investment with no risk, also known risk free rate
- We generally use the yield of the treasury bond as the risk free rate since treasury bonds are guaranteed by the US government they’re considered the most risk-free investment available.
m = β, (beta), a stock’s volatility compared to the overall market
- So if a stock has a beta of 2 and the stock market moves up 1%, the stock will move up 2%.
X = market risk premium, the risk of the investment
- Market risk premium = expected rate of return – the risk free rate
- “How much risk are you taking on?”

The end result becomes: Expected return = Risk-free rate + β(market risk premium) also known as the Capital Asset Pricing Model (CAPM). This determines what you should expect to earn based on the level of risk you take on.

Takeaways

We only care about common risk because we can diversify idiosyncratic risk.
CAPM is what we use to determine the expected return of an investment.
The higher the risk we take on, the more we should be compensated for it.

Compound Finance: Crypto Marketplace Lending

Compound is a decentralized platform for lending and borrowing crypto.

The Defi Lending Problem & Compound’s Solution

One of the greatest issues with decentralized finance is the anonymity of blockchain. In the prior MPL and bank lending analyses, there was always an analysis of the credit risk of the borrowers. Because of the anonymous structure of blockchain, the amount of risk associated with lending increases, since transacting parties stay mostly anonymous.

Compound seeks to solve this issue using over-collateralization. Compound requires borrowers to collateralize their loan by leaving something of value at Compound greater than what they’re borrowing (so if they sought to borrow ETH worth $1,000, they may have to leave BTC worth $1,500).

This begs the question, why would you take a loan out if you already have more than the amount you need? Compound’s service essentially allows borrowers to ‘lever’ themselves upon certain bets. This is a practice not unlike that of borrowing through a home equity loan. If a compound user is extremely confident ETH will go up, they may collateralize their BTC to borrow ETH.

However, borrowers have to beware that if their collateral drops in value below the required ratio of collateral to debt, their collateral will be liquidated.

How are interest rates determined?

You can usually borrow for as long as you want in terms of duration, as long as you maintain the collateralization ratio, because there is no mechanism to force people to pay back their loans. This means that they can just freeze their collateral forever if they want.

The issue for savers on account of duration results in the utilization ratio.

The formula is:

Utilization ratio = Amount borrowed/ Amount lent.

The utilization ratio must always be less than 1, because you can’t borrow more than what is available and it cannot be 1 because you always want some money available to borrowers. The utilization ratio in reality tends to be managed by the collateralization ratio because of limits to how much borrowers are able to borrow.

Whatever interest is paid by the borrower will get split by the lenders in the pool. The interest rate of a supplier can therefore be said to be utilization ratio * interest of the borrower.

So how does Compound ensure a utilization ratio less than 1? Compound increases the interest rate of the borrower and the saver. That encourages more people to invest in the pool and fewer people want to borrow.

Those interest rates are constantly updated every block based on how much money is in supply and how much is being borrowed.

If interest rates are going up, what exactly is the risk that is being accommodated for (and therefore what are the concerns with a high utilization ratio). Given all loans are over-collateralized, there is no concern about receiving your principal. Instead, you take on liquidity risk because while there will always be money collateralized there is no guarantee that the collateral will be returned.

Therefore, if the lender has no risk (aside from slight liquidity risk), how much interest should the borrower be paying? In traditional finance, that would imply a rate approximating the risk-free rate, basically 0.05% according to the 3 Month treasury. But borrowers do not pay 0.5% on Compound. However, they are paying 10% because of the utilization ratio.

In theory, even the rate Compound charges are likely too high, because investors receive cETH as a receipt for their lent money. Because the value behind this is guaranteed by the collateral pool, the saver should be able to use this cETH as a proxy for the value of their investment and maintain their liquidity levels. That should in theory lower the borrowing costs for borrowers as the liquidity risk is lower.

Aave: Another Defi Paragon

What is Aave?

Aave is another decentralized finance protocol that also enables borrowing and lending just as Compound does. Just like Compound, Aave requires collateralization and is non-custodial, meaning that nobody else manages or owns their collateral in the intervening period. Where compound issues the cETH, Aave issues the “Aave” and aToken tokens. The aToken gets pegged against your lent or borrowed assets (BTC, ETH, etc.) and gets pegged on a 1:1 basis. The Aave acts as a governance token to manage the future of the protocol.

Aave’s Special Focus: The Flash Loan

One of Aave’s greatest differentiators from Compound is flash loans. Flash loans are trustless, no collateral loans, where transactions all happen within the same block. If a borrower does not pay back the flash loan, using smart contracts prebuilt into the block, the transaction is essentially voided as though it never happened.

Flash loan uses:

· Arbitrage: Flash loans create arbitrage opportunities when markets are not synced in the prices of certain cryptocurrencies. Because of the safety of the flash loans (the fact that they can void the transaction if they’re not paid back), the flash loans tend to carry extremely low-interest rates. These movements can eventually result in market manipulation and flash loan attacks.

· Collateral Swap: Collateral swaps allow borrowers to quickly pay their Compound balance off, swap the collaterals on a crypto swap market, and then reborrow.

· Self-liquidation: Using the same principle as the collateral swap, it is possible to pay back a Compound loan to take back collateral, use the collateral to pay off the flash loan, and keep whatever is remaining.

· Flash loan attacks: see our dedicated article about flash loan attacks

In Conclusion

Decentralized finance is still a very nascent, fast-growing space. Decentralized finance offers the typical advantages like anonymity of decentralization, as well as a potentially far lower interest rate than borrowers may find at a bank. They offer the chance for great money-making potential through leverage and flash loans and decrease the necessity to rely on trustworthiness among all actors.

Some issues do remain for decentralized finance to wrestle with. Beyond its current legal controversies, some mechanics remain to be ironed out. For one, most longer-term lending necessitates over-collateralization and instant price updates. While this may work for long/short approaches to cryptocurrencies that have investors and instant market price information if the long-term goal is purchase and sale of larger, more common purchases like cars or houses, complexities behind proving the value of homes and being able to create the additional “over” in the over-collateralization stand as issues that would have to be overcome.

Additionally, given recent flash loan attacks, further security enhancements are likely necessary to avoid additional losses for savers in the system. As the space matures and governance continues to improve, it will be interesting to see how decentralized finance continues to grow into the mainstream.

Further Reading