Decentralized Finance Lending Track Insight Analysis Report: Development Trends, Key Challenges and Outlook

Dear reader,

I am honored to introduce to you the "2023 Global Decentralized Finance Lending Track Insight Analysis Report." This report is carefully crafted by our team, combining academic research and industry practice, to share the成果 and insights born from our collective wisdom.

In the past few years, the rise of Web3 technology has led to significant changes in the financial industry. Web3, characterized by decentralization, security, transparency, and programmability, has brought unprecedented opportunities and challenges to the lending sector. With the help of technologies such as blockchain, smart contracts, and cryptocurrencies, the financial market is experiencing a transition from traditional centralized models to decentralized models.

This report aims to explore in depth the development trends, key challenges, and outlook of the Web3 lending sector. We will provide a comprehensive overview of key topics such as Web3 lending protocols, decentralized lending markets, asset collateralization, and risk management. Additionally, this report will introduce some of the latest lending innovation cases, exploring how Web3 technology facilitates the development and innovation of financial markets. We will discuss emerging areas such as blockchain-based lending protocols, decentralized lending platforms, and lending derivatives, and examine their potential impact on the traditional financial system.

We hope that this report can provide readers with a comprehensive perspective on the Web3 lending sector and offer valuable references for practitioners in the industry, researchers in academia, and policymakers. We believe that with the development of Web3 technology, the lending market will become more open, efficient, and inclusive, contributing to the sustainable development of the global financial system.

Finally, I would like to sincerely thank our team members for their hard work and support, as well as our readers for their attention and support. I hope this white paper can bring you inspiration and guidance.

May our joint efforts promote better development in the financial world and pave the way for the future of financial technology. Let's encourage each other!

Preface

Lending is the beginning of everything in the financial market; it is the origin.

Whether it is "The Wealth of Nations" or Mankiw's economics textbook, we can easily understand that the core of financial activities is built on the foundation of trust among people. Trust allows individuals to lend funds or assets to each other, thereby achieving the optimal allocation of resources.

Lending is a credit activity, where the lender provides monetary funds to the borrower at a certain interest rate and under specific conditions to meet their production or consumption needs. In lending activities, the borrower can increase their returns by leveraging their capital, which is the effect of leverage. However, leverage can also amplify the borrower's risks; if the borrower fails to repay on time, it could result in losses or even bankruptcy. To avoid or transfer such risks, various financial derivatives have been invented, such as futures, options, and swaps. These financial derivatives can be used to hedge against or speculate on market fluctuations. It is no exaggeration to say that finance and financial derivatives are built upon the foundational proposition of "lending."

Due to the inconveniences of centralized finance, people are turning to blockchain, hoping to achieve more efficient, fair, and secure financial services through decentralized methods. Decentralized lending is one important application scenario, utilizing smart contracts to match borrowers and lenders, lock assets, calculate interest, and execute repayments, without relying on any third-party institutions or individuals.

As of now, the on-chain DeFi lending track has become one of the most important tracks in the blockchain market, with a TVL of $14.79b. However, the current DEF lending protocols lack innovation, and market focus is gradually shifting. The question that innovators face is how to innovate based on existing models and combine them with the latest technologies.

The DeFi lending sector needs a new narrative.

Part 1: DeFi Lending Principles Explained: How Decentralization is Changing the Development of Financial Lending

The Distributed Transformation of Financial Infrastructure: From Traditional Finance to Decentralized Finance

A core function of the financial sector is to channel savings into productive investment opportunities. Traditionally, savers deposit their money in banks to earn interest; banks then lend the funds to borrowers, including businesses and households. Crucially, as lenders, banks screen borrowers to assess their creditworthiness, ensuring that scarce capital is allocated to its best use.

During the screening process, banks combine hard information and soft information, where the former includes the borrower's credit score, income, or educational background, while the latter is usually obtained through extensive relationships with the borrower. From this perspective, the history of financial intermediation is an exploration of improving information processing. For borrowers who are difficult to screen, lenders may require collateral to secure the loan, thereby alleviating information asymmetry and coordinating incentives. For example, entrepreneurs often have to pledge their home equity when applying for loans. If default occurs, lenders can seize the collateral and sell it to recover losses.

For centuries, collateral has played a ubiquitous role in lending, with loans secured by real estate dating back to ancient Rome. As time has passed, the market vehicles and forms have changed, and DeFi lending platforms have brought together depositors and potential borrowers without a central intermediary like a bank. More accurately, lending activities occur on the platform or through a series of smart contracts that manage loans according to predefined rules. On one side are individual depositors (also known as lenders) who deposit their crypto assets into so-called liquidity pools to earn deposit interest rates. On the other side are borrowers who obtain crypto assets and pay borrowing interest rates. These two rates vary based on the crypto assets and the demand for loans, while also being influenced by the size of the liquidity pool (which represents the supply of funds). Platforms typically charge borrowers a service fee. Since the process is automated, loan issuance is almost instantaneous, and the associated costs are very low.

A key difference between DeFi lending and traditional lending is the limited ability of DeFi lending to screen borrowers. The identities of borrowers and lenders are concealed by encrypted digital signatures. As a result, lenders are unable to access information such as the credit score or income statements of borrowers. Therefore, DeFi platforms rely on collateral to align the incentives of borrowers and lenders. Only assets recorded on the blockchain can be borrowed or pledged, making the system largely self-referential.

A typical DeFi loan is issued in stablecoins, with collateral consisting of higher-risk unsecured crypto assets. Smart contracts assign a haircut or margin to each type of collateral, determining how much minimum collateral a borrower must provide to obtain a given amount of loan. Due to the high volatility of crypto asset prices, the collateral required for over-collateralization is often much higher than the loan size, with minimum collateral rates on major lending platforms typically ranging from 120% to 150%, depending on the expected price appreciation and volatility.

• The exploratory period (2017-2018) was the initial stage of the DeFi ecosystem, during which a number of decentralized finance protocols based on smart contracts emerged on the Ethereum platform, providing users with various types of cryptocurrency lending services. Among them, MakerDAO is one of the earliest stablecoin issuance protocols, allowing users to generate DAI stablecoins by collateralizing cryptocurrency assets; Compound is one of the first interest market protocols, enabling users to deposit or borrow cryptocurrency assets while dynamically adjusting interest rates based on market supply and demand; Dharma is one of the earliest bond issuance protocols, allowing users to create, buy, or sell fixed-rate bonds based on cryptocurrency assets. These protocols laid the foundation for the DeFi ecosystem and provided inspiration and reference for later innovators.

• The outbreak period (2019-2020) was a phase of rapid growth for the DeFi ecosystem. During this period, the on-chain lending market exhibited characteristics of diversification and innovation. Not only did more DeFi projects enter the market competition, but many lending protocols also innovated and optimized to meet different user needs and market conditions. These lending protocols involved various crypto assets, including stablecoins, native tokens, synthetic assets, and NFTs; employed different risk management strategies, including collateral ratios, liquidation penalties, insurance pools, and credit scoring; designed various interest rate models, including fixed rates, floating rates, algorithmic rates, and derivative rates; and implemented different governance mechanisms, including centralized governance, decentralized governance, community governance, and token incentives. These lending protocols also achieved a higher degree of interconnectivity and synergy, providing users with richer and more flexible financial services and yield opportunities through smart contracts and composable strategies. Notable lending protocols that emerged or developed during this period include Aave, dYdX, Euler, and Fraxlend, each with its unique advantages, but also facing challenges and risks.

• Expansion Period (2021 to present) On-chain lending track is facing more challenges and opportunities. On one hand, as the Ethereum network becomes congested and transaction fees rise, lending protocols are beginning to seek cross-chain and multi-chain solutions to improve efficiency and reduce costs. Some lending protocols have already deployed on other public chains or adopted cross-chain bridging tools to achieve interoperability of assets and data, such as the fully on-chain lending protocol Radiant. On the other hand, with the demand and attention from the real economy and traditional finance, lending protocols are also exploring the possibility of bringing real-world assets (RWA) on-chain to expand the scale and influence of the lending market. Some lending protocols have already attempted to convert assets such as real estate, cars, and notes into on-chain tokens and provide corresponding lending services, with representative lending protocols including Tinlake, Centrifuge, and Credix Finance.

The core elements of Decentralized Finance lending

Whether it is decentralized lending based on blockchain technology or traditional lending based on financial institutions, their core components have certain similarities. Regardless of the lending method, there are essential elements such as borrowers, lenders, interest rates, terms, and collateral. These elements form the basic logic and rules of lending, determining the risks and returns of the loan. In decentralized lending, various parameters are determined by the DAO, thus adding a governance module to the entire financial model. Specifically, it includes the following several elements:

• Borrower: A borrower refers to the party that needs to borrow funds. They typically have a need for funds for purposes such as investment, consumption, emergencies, etc. The borrower needs to submit a loan request to the lender or platform and provide some necessary information and conditions, such as the loan amount, term, interest rate, collateral, etc. After obtaining the loan, the borrower is required to repay the principal and interest to the lender or platform in the agreed manner and timeframe.

• Lender: A lender refers to the party willing to lend funds, typically holding some idle capital they wish to earn a return on. Lenders need to provide their funds to borrowers or platforms and accept some necessary information and conditions, such as loan amount, term, interest rate, risks, etc. After lending the funds, lenders must recover the principal and interest according to the agreed manner and time.

• Platform: A platform refers to a party that acts as an intermediary or coordinator in the lending process. They can be centralized institutions, such as banks, credit unions, and online lending platforms, or decentralized systems, such as blockchain, smart contracts, and Decentralized Finance platforms. The main function of the platform is to provide a trustworthy and efficient lending market for borrowers and lenders, achieving the matching of funds and