The danger of over-collateralized lending to DeFi and the new type of Solo protocol lending
“If you don’t know what crypto leverage is, you don’t know anything about crypto, no matter what you think you know.” These are the words of Dr. Michael Burry, founder of Scion Capital, once played by Christian Bale in The big short.
The regular Cassandra (as her Twitter account puts it) and the arch-pessimist have pronounced the fate of the crypto markets due to excessive over-leverage. The fate he foretold didn’t happen enough sweat, but crypto certainly took a bit of a hit in the summer of 2022 as markets tipped in the face of global headwinds.
Why Crypto is Collapsing So Quickly
Why is crypto prone to a total and dramatic collapse? There are several reasons: it’s a speculative asset, retailers are jostling like wildebeest overnight, big players are almost certainly involved in the manipulation, and the real usefulness of crypto is still very immature, and the users quickly lose confidence. Not to mention the security risks. It is a volatile world and will remain so until crypto has at least a few more years in the fiery forge of the markets. Even with these issues, the volatility of cryptos is far too extreme.
One of the main, less talked about reasons for the crypto craze is the amount of over-collateralized loans that exist in the DeFi space. In short, traders are mounting their crypto as collateral in order to borrow more and more stablecoins, and then using those stablecoins to take even longer positions in the crypto market.
This behavior temporarily boosts the entire market but ends up locking up chain after chain bond liquidity. This composability, which has led to the huge growth of DeFi on a relatively small user base (as a fraction of the whole population), also has the potential to cause cascading liquidations as funds are lost. when positions fail and cause repercussions on the whole ecosystem. .
How over-collateralization works in DeFi
Overcollateralized loans are how DeFi lending and borrowing is done. In protocols like Maker, Compound, Aave, and many others, oversizing is the norm. Users must provide After capital than they borrow to take out a loan. There are several reasons for this, but in short, these power traders hope that the money they earn from the investment will grow faster than the debt on the loan. This means they can invest the capital value of an asset (like ETH) without having to risk or liquidate their exposure to the asset itself. As long as they can pay the interest, they can have their cake and eat it.
In a bull market, such aggressive leverage makes sense and can be dramatically effective. Yield farm strategies involving vast multi-protocol borrowing cards have provided spectacular returns for those with the know-how, expertise and a fair amount of luck to take advantage of them.
The major problem of over-secured loans
There is one major problem with these loans, however. As every trader is maxed out, if the price of, say, Ethereum drops dramatically – suddenly the loan collateral is worth significantly less than the loan amounts. This could put the protocol out of business, so as it approaches problematic levels, they liquidate the collateral as a defensive measure, leaving the trader stuck. They even incentivize liquidators to engage in this activity for a bonus reward to ensure its effectiveness, which means collateral on loans is closely monitored and immediately sacrificed if levels are exceeded.
It has long been a major headache for traders, but with the volatility of crypto, it becomes a Damocles sword ready to decapitate the entire market. And, if the price of an asset is in freefall, liquidators may not even be active, because the rewards aren’t there.
A rapid price drop – so often in crypto – can thus bankrupt DeFi lenders, wiping out their users’ funds and the protocol’s treasury, in an instant. Even the biggest and best are hurting, like when MakerDAO suffered cascading hard selloffs as a result of price activity on March 12, 2020.
How Composability Makes Leverage Dangerous
The situation gets worse when you factor in the interconnectedness of DeFi. There are many protocols that rely on AAVE, for example, to provide its services and interact with AAVE’s smart contracts. If the price of AAVE were to drop and the protocol were to go bankrupt or experience a liquidity crisis, then the protocols that intertwine with its smart contracts could also go bankrupt, even if their liquidity and smart contracts were robust. Leverage in DeFi is therefore both a supercharged pathway to growth and a ticking time bomb to dissolution, due to the domino effect of oversized loans.
Representative assets and LP tokens are also problematic. Perhaps you are using a representative asset to secure a loan that you are using to mine liquidity in a different protocol. If this representative asset suddenly loses value, for example in the event of a smart contract hack, your loan collateral is immediately liquidated, or you may need to withdraw funds from the cash mine to provision capital to your position , which can harm any chance for the invested protocol to grow.
How the SoLo protocol will create alternatives to oversecured loans
The list continues. Overcollateralized loans are a powerful way to make money grow, but they pose systemic risk to DeFi if they are the only type of loan a user can take out. Plus, they’re useless for average retail users. What DeFi needs are under-collateralized loans, closer to a personal loan. These loans mimic the type of loans you see in TradFi. This is what SoLo Protocol (SoLo), a decentralized, noncustodial protocol that issues these types of loans, will bring to the space.
The reason oversecured loans are given so freely is that no one checks who you are. Why would they? If I gave you $1,000 as collateral and asked you to lend $100, most would. There is no risk. Under-secured loans are obviously different – the lender must ensure that it is repaid. In TradFi, lenders use credit scores. Newer systems like Credit Kudos have used machine learning on open banking data. The Bank of England has already said that it is “improving the selection of risky borrowers”, and SoLo will do so as well.
“We want to take advantage of the huge advances in machine learning in credit data scoring and combine it with on-chain analytics to create a new type of hybrid score – the SoLo score,” says Louis L, co-founder by SoLo.
This blend of machine learning generated credit scores that were built into TradFi to make Web3 and DeFi lending decisions. In addition to using this traditional marker, it will also use on-chain wallet activity to decide whether to grant a loan and to determine the creditworthiness of the lender.
“This fusion of on-chain and off-chain data is not done by anyone, SoLo is the first, and the impact on the space will be huge,” says Tom G, another co-founder. “The SoLo score will be a completely unique score that the protocol uses to make our loan decisions.”
Baby, You Got a Soul: How the Solo Protocol Will Merge TradFi and DeFi
These “traditional” types of on-chain loans have some interesting ramifications. Users with good credit in TradFi or a positive history of transaction data assessed by machine learning can easily obtain crypto loans for web3 investments. Users who struggle to get traditional loans but have excellent on-chain portfolio metrics can access more capital than they otherwise could. Issuance of under-collateralized loans has the potential to create new wealth in the crypto markets and onboard millions of additional users into the web3.
While using traditional banking data sounds scary, it actually makes a lot of sense. There are already robust systems for determining who to lend to in the traditional financial industry that have used machine learning on transaction data – why not use it to make web3 a better place. This is precisely what SoLo does. Their beta product is now live on their website, so be sure to check out your SoLo score and explore the new horizon of consumer credit.