Amid the web 3.0 and digital tokens (crypto and bitcoin) being trumpeted as the next iteration of the internet, uncollateralized lending is no longer a far-out term. It has gained traction with the rapid growth of cryptocurrencies. The global crypto market has attained brisk momentum and reached a record value, with Bitcoin and Ethereum marking a growth of 9200% and 33500% respectively (2016-2022). This has resulted in the growing interest of institutional investors, creating a broader ecosystem of uncollateralized lending.
Decentralized lending refers to lending that isn’t backed with any collateral as security in the event of default or payment failure. Lenders simply issue funds based on the creditworthiness of a borrower. However, unsecured lending has evolved the financial world with a really rolling shift to tokenization of financial services.
However, you could be wondering about how Web 3.0 impacts decentralized lending?
Web 3.0 & The Uncollateralized Lending Era
There’s no denying the fact that blockchain technology and its use cases are much exciting. On this note, uncollateralized lending and web 3.0 are on the cusp of significant growth.
The instantaneous lending scenario, enabled by Web 3.0 has made finance easily available with reduced loan processing time in the absence of any intermediary or regulatory authority. It has nearly answered the lengthy loan processing conundrum effectively.
Flash loans, the most hyped concept influenced by crypto, is the common example of unsecured lending in DeFi. These short-term collateral-free loans are encoded in a smart contract that empowers the user to reimburse the amount in the same transaction on the Ethereum blockchain.
With more stakers moving to the Web 3.0 and uncollateralized lending bandwagon, there’s been an upsurge in such protocols. The protocols usually allow lenders to deposit their crypto in a pool and algorithmically manage interest rates based on the market scenario.
Aave’s credit delegation product was the first partial unsecured lending facility that attracted several investors with a vested interest in the protocol. Aave protocol has a multi-market approach and enables users to deal with Liquidity Provider tokens that represent a lender’s share of the pool. In Aave, lenders deposit cryptocurrency into the lending pool, and borrowers borrow them at market rate APR. Parties directly interact through the lending pool and Ethereum smart contract.
TrueFi is another industry-leading protocol that works through the on-chain credit scores and TRU tokens. The functions begin with lenders adding crypto-assets into the lending pool. Followed by this, borrowers are whitelisted after the firm authentication and verification process. Institutional borrowers once verified, are provided with capital at an agreed interest rate based on their credit score for a specified period.
The next most trusted decentralized lending protocol includes Teller Finance. It is an algorithmic protocol that connects to your bank account and offers loans without any collateral needs. The users can simply act as liquidity providers by depositing assets into liquidity pools and can earn $TLR token and $COMP tokens. To apply for decentralized lending, you can visit the app, select the loan type, size, period, and percentage.
Compound Finance is another top DeFi lending protocol that lets users gain interest by lending assets to borrowers. Users deposit cryptocurrencies and earn interest on them by lending as per rates set by algorithmic smart contracts. It doesn’t work on Token-to-Token matches, which means a lender first deposits his assets into the platform, which in turn supplies to the borrower.
With the advent of crypto markets reaching an all-time high and Web 3.0 taken off by this storm, uncollateralized lending has also made rampant growth. Let’s have a rundown of how this earlier holy grail has now turned out to be a known part of numerous use cases.
Uncollateralized Lending: Why Does it Matter?
Overcollateralized lending is considered capital inefficient, while collateral-free lending plays an effective role in DeFi lending. It is largely scalable and could foster several lending arrangements, leveraging the mode as the better capital source. Quick funding, larger amounts, flexibility, fewer qualifying criteria, no restrictions, and similar benefits make it vital financing amid the present-day Web 3.0 driven market.
Unsecured lending provides lenders an opportunity to earn better long-term returns as compared to secured lending and for borrowers to increase their capital efficiency. Also, the system seems beneficial for borrowers as well as for the market. The minimized locked up amount increases liquidity in the market and makes it highly active.
Top Pros and Cons of Unsecured Lending
Pros of Uncollateralized Lending
With Web 3.0 inevitably gaining enormous impetus, collateral-free lending has got wind in its sails for numerous reasons.
- Minimal Processing Time
Lending and borrowing are made much simple than ever. It involves a seamless application process and minimal time while transacting as compared to traditional methods. Easy availability and amount getting disbursed in a short period make it a preferred lending source for many.
- Reduced Risks
The most vital advantage of going for an uncollateralized transaction is the absence of risk on the borrower. S/he doesn’t need to face the threat of losing assets/property kept as collateral security. Also, it is a cost-effective medium for those who’re not having enough valuable possessions with them.
- Higher Flexibility
They’re highly flexible and can be used for every purpose. You’re not bound to use them for a specific purpose such as an automobile or housing.
Cons of Uncollateralized Lending
Collateral-free platforms do maximize borrowers’ capital efficiency but they pose manifold risks related to technology, compliance and more.
- Firm eligibility criteria
For the reason that security-free financing is not backed by any security, lenders often set tough criteria. The common instances include high credit scores, no underlying debts, and more.
- Technological Risks
The tech-related risks are rooted in the blockchain with protocols powered by smart contracts. The increase in bugs, cybersecurity threats, identity theft, faulty transactions, system bugs, and more lead to high transaction fees and severe transactional errors.
- Asset Risks
Such a type of lending is mainly backed by cryptocurrency/digital assets. The volatile nature of digital assets could influence collateral value( major spike or sharp decline) and poses liquidity risks. This in turn results in uncertainty and can even lead to bank runs.
- No Central Regulatory Body
The absence of regulatory institutions and intermediaries, initiated by Web 3.0 creates despotic risks and results in an uncertain lending ecosystem. The transactions occur in anonymity without authenticating the user identity, often leading to added risks of money laundering, identity theft, and other illicit activities.
Parties in the FinTech landscape have long had to roll with the evolving punches of dynamic trends. No Decentralized lending being widely considered as an alternative to collateralized lending is not an exception. It surely encounters several risks onto a new phase of the internet, web 3.0, established in the absence of a regulatory medium or intermediary.
Participants planning to transact in such an outlook should take stock of risks, analyze the deal and identify the risks, prior to deciding over using unsecured networks. The financial ecosystem has just required the right circumstances to use the right technology to adopt the unsecured lending and materialize DeFi. Now that it has gotten to grips with the FinTech ecosystem, collateral will surely become a subset of the lending equation.