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How DeFi Lending is Different from Traditional Lending
In his article, DeFi Protocols Don’t Do “Lending,” Chervinsky argues that DeFi lending is not lending because it does not involve a trust-based creditor-debtor relationship.
In a typical lending relationship, a creditor assesses the creditworthiness of a borrower to decide whether or not to take the risk of issuing a loan. If the loan is issued, then the borrower is expected to repay the loan after an allotted time with interest.
Regardless of a borrower’s creditworthiness, this type of transaction inherently comes with some default risk.
In Chervinsky’s point of view, these two elements of credit and risk are essential for a transaction to be considered a loan. Since DeFi lending platforms do not involve either, he claims, they should not be considered loans.
Here is how DeFi lending is set up to operate without using either credit or risk.
Permissionless, peer-to-pool relationship
DeFi lending platforms are built on permissionless blockchains. This means that anyone can pseudonymously use the protocol to borrow or lend. This makes it difficult to trace who the parties are in real life and thus eliminates the possibility to assess a person’s creditworthiness.
In addition, funds are borrowed from the ‘pool’ of funds rather than directly from specific lenders. Since it can’t be determined exactly whose assets are being borrowed by whom or from whom, it is impossible to establish a clear lender-borrower relationship.
As a result, DeFi lending platforms are built to function entirely without trust or a system of credit. Instead of using credit, DeFi lending is based on a system of overcollateralization and liquidation to facilitate transactions between unclear and unknown lenders and borrowers.
Overcollateralization and Liquidation
Without credit in DeFi lending, collateral is everything.
Through a DeFi lending platform, in order to get a ‘loan,’ one must first stake some digital assets. These assets are ‘locked’ up and allow the borrower to borrow another digital asset in an amount less than the value of their collateral.
For example, if 100 ETH is locked in the platform, they can borrow up to 60–75% of that value in other assets. E.g., 50 ETH worth of USDC.
As Chervinsky points out, this differs from a traditional loan, which allows a borrower to receive money guaranteed only by their credit.
This system of overcollateralization significantly lowers the risk for lenders. If a borrower fails to repay a loan, his collateral is more than enough for repayment. If at any point the borrower’s position drops below his borrowing limit because the value of his collateral has dropped, then the platform can automatically liquidate his position and repay his lenders.
If you compare this structure to the standard personal loan, it’s clear that it’s a very different kind of lending. However, if you look at it closely, this setup resembles a very common form of secured lending.
As I’ll demonstrate below, the way that DeFi platforms are structured is very similar to margin lending in the traditional securities world.
DeFi lending vs. Margin lending
Margin lending is a practice where a person is able to borrow against the value of existing securities that they own. This is typically used by stock traders to make bigger bets than they otherwise could on the stock market. Though many margin borrowers simply take cash.
Just like with DeFi lending, with traditional margin lending, a borrower must put up a certain amount of assets in order to receive a loan at 50%-75% loan-to-value. For example, if an investor has $1,000 worth of Microsoft stock, JP Morgan will let him borrow an additional $500-$750.
In both situations, the loans are not based on a borrower’s creditworthiness, simply on the amount of collateral they have provided. If the value of a borrower’s position falls below the borrowing limit, their assets will be automatically sold to secure the loan. And while borrowers have the option to repay their loans with interest, their collateral may also be used to substitute repayment.
As you can see, the similarities between DeFi lending and margin lending are obvious.
While there may be a clearer lender-borrower relationship in margin lending than in DeFi lending, this does not have any impact on whether or not the activity is considered ‘lending’.
In traditional finance, there are countless examples of loans made to or from indistinct parties, a consortium of banks or a group of bondholders for example. There are also non-digital lending pools, which are regulated despite not having individual lenders and borrowers.
Perhaps Chervinsky’s best argument to differentiate between DeFi and traditional margin lending is that borrowers who take out margin loans from their securities are personally on the hook. However, in nearly all cases, their collateral is sufficient to repay the loan and the need for personal liability is irrelevant.
As a result, regulators will likely approach DeFi lending in the same way they approach margin lending.
What this means for DeFi regulation
DeFi lending projects can and very likely will be regulated in a similar way as financial institutions that offer margin lending.
The primary regulations surrounding margin lending are regulated by the Board of Governors of the Federal Reserve System. In practice, however, the SEC, the CFTC, the NYSE, and FINRA have all been involved in regulating margin lending over the past century.
On top of this, regulators typically require all lending institutions to register with them as a bank, a non-bank lender, or a broker-dealer. This applies to both centralized and decentralized projects.
What does this mean for Crypto Law Insiders?
For Insiders, it is essential to understand that new jargon and buzzwords simply do not matter to regulators.
It doesn’t matter if a project claims that it is not a bank and that it is just a “technology” or a “protocol”. Nor does it matter if the project claims to be decentralized.
If a project facilitates loans or interest payments to users, then it likely qualifies as engaging in lending activity.
Given that Compound has already registered its securities offerings with the SEC. I think it’s taking a large risk by not pursuing proper licensing in regards to its lending platform as well.
Just as with ICOs in recent years, DeFi will eventually face a regulatory crackdown. A project may be able to get away without registration in the early days, but if it wants to survive in the long term, it will need to comply. Sooner rather than later.
Originally published at https://cryptolawinsider.com.
DeFi Lending: How Will it be Regulated? | Crypto Law Insider was originally published in The Capital on Medium, where people are continuing the conversation by highlighting and responding to this story.