From Speculative to Practical: What's Next for the On-Chain Lending Market?

Author: equilibrium

Translation: Shan Oba, Golden Finance

As the cornerstone of internet finance, the vision of the on-chain lending protocol is to provide fair access to capital for individuals and businesses around the world, no matter where they are located. This model helps build fairer and more efficient capital markets, which in turn drives economic growth.

Despite the huge potential for on-chain lending, the current main user base is still crypto-native, and their use is mostly limited to speculative trading. This drastically limits the total amount of market (TAM) it can cover.

This article explores how to gradually expand your user base and transition to a more productive lending scenario, while addressing the challenges you may face.

The current state of on-chain lending

In just a few years, the on-chain lending market has evolved from a concept stage to a number of market-tested protocols, which have undergone many highly volatile market tests without generating bad debts. To date, these agreements have attracted a total of $43.7 billion in deposits and issued $18.6 billion in outstanding loans.

! [From Speculation to Utility: What's Next for the On-Chain Lending Market?] ](https://img.gateio.im/social/moments-cdb21ea816daafe44d4f6fe4d8fa78ef)

Source: DefiLlama

! [From Speculation to Utility: What's Next for the On-Chain Lending Market?] ](https://img.gateio.im/social/moments-5d33ca858ccde18dde50c0fb87e8aa7f)

Source: Artemis

Currently, the main sources of demand for on-chain lending protocols include:

• Speculative trading: Crypto investors use leverage to buy more crypto assets (e.g., borrowing USDC with BTC as collateral and then buying more BTC, or even cycling multiple times to increase leverage).
• Access to Liquidity: Investors borrow to access liquidity in crypto assets without having to sell them, thus avoiding capital gains tax (depending on the jurisdiction).
• Arbitrage flash loan: A very short-term loan (borrowed and returned within the same block) that is used by arbitrage traders to take advantage of a temporary price imbalance in the market and make a price correction.

These apps primarily serve crypto-native users and are predominantly speculative. However, the vision of on-chain lending is much more than that.

Compared to the $320 trillion in global outstanding debt, or $120 trillion in loans to households and non-financial corporations, the current $18.6 billion in outstanding loans for on-chain lending protocols is only a paltry fraction of that.

! [From Speculation to Utility: What's Next for the On-Chain Lending Market?] ](https://img.gateio.im/social/moments-57be333401afc5ea7d970eecc691b7a4)

Source: Institute of International Finance Global Debt Monitor

As on-chain lending transitions to more productive uses of capital, such as small business financing, personal car purchases, or home loans, the market size (TAM) is expected to grow by several orders of magnitude.

The future of on-chain lending

To improve the usefulness of on-chain lending, two key improvements need to be made:

1. Expanding the scope of collateral assets

Currently, only a few crypto assets can be used as collateral, which greatly limits the number of potential borrowers. In addition, to compensate for the high volatility of crypto assets, existing on-chain lending often requires collateral ratios of up to 2x or more, further dampening the demand for borrowing.

Expanding the range of acceptable collateral assets will not only attract more investors to use their portfolios for borrowing, but also increase the lending capacity of on-chain lending protocols.

2. Promoting ultra-low mortgage lending

Currently, most on-chain lending protocols employ an overcollateralized model (i.e., the value of the collateral assets that the borrower must provide is higher than the borrowed amount). This model leads to inefficient use of capital, making it difficult to implement many real-world use cases, such as small business financing.

By adopting ultra-low collateral lending, on-chain lending can reach a wider group of borrowers and further enhance its practicability.

The difficulty of implementing these improvements varies, with some being relatively easy to implement while others present new challenges. However, the optimization process can be progressively progressive, from easy to difficult.

In addition, fixed-rate lending is also an important feature in the development of on-chain lending, although this problem can be addressed by a third party assuming the borrower's interest rate risk (e.g., through an interest rate swap or a custom agreement between the borrower and the borrower), so it will not be discussed in detail in this article (there are existing agreements, such as Notional, that provide fixed-rate lending services).

1. Expand the scope of collateral assets

Compared to other asset classes around the world, such as public equity markets ($124 trillion), fixed income markets ($140 trillion), and real estate markets ($380 trillion), the total market capitalization of the cryptocurrency market is only $3 trillion, which is only a small fraction of global financial assets. As a result, limiting the scope of collateral to a subset of crypto assets significantly limits the growth of on-chain lending, especially when collateral requirements are as high as 2x or even higher to compensate for the high volatility of crypto assets.

Combining asset tokenization with on-chain lending allows investors to more efficiently leverage their entire portfolio for borrowing and lending, rather than being limited to a small portion of crypto assets, broadening the pool of potential borrowers.

The first step in expanding the scope of collateral assets may start with liquid, frequently traded assets (e.g., stocks, money market funds, bonds, etc.) that have less impact on existing lending agreements and are less expensive to change. However, the speed of regulatory approvals will be a major limiting factor for the growth of this sector.

In the longer term, expanding into less liquid physical assets, such as tokenized real estate ownership, will offer significant growth potential, but it will also introduce new challenges, such as how to effectively manage the debt position of these assets.

Eventually, on-chain lending may evolve to the point where the property is mortgaged for mortgage lending, i.e., the loan origination, the purchase of the property, and the deposit of the property into the lending agreement as collateral can be done atomically within a block. Similarly, a business can also be financed through a lending agreement, such as the purchase of plant equipment and at the same time depositing it as collateral in the agreement.

2. Promote low-collateral lending

Currently, most on-chain lending protocols use an overcollateralized model, where the value of the collateral assets that the borrower must provide is higher than the amount borrowed. While this model ensures lender safety, it also leads to inefficient use of capital, making it difficult to implement many real-world use cases, such as small business working capital loans.

Within the crypto industry, the initial demand for low-collateral lending is likely to come from market makers and other crypto-native institutions that still need access to funding after the collapse of centralized lending platforms (e.g., BlockFi, Genesis, Celsius). However, early attempts at decentralized low-collateral lending (such as Goldfinch and Maple) mostly put the lending logic off-chain or eventually moved to an overcollateralized model.

One new project to keep an eye on is Wildcat Finance, which seeks to reintroduce low-collateral lending while retaining more on-chain components. Wildcat only acts as a matching engine between borrowers and lenders, allowing lenders to assess the borrower's credit risk on their own, rather than relying on an off-chain credit review process.

Outside of the crypto industry, low-collateral lending has been widely used for personal loans (e.g., credit card debt, BNPL buy now, pay later) and business lending (e.g., working capital loans, microfinance, trade finance, and corporate lines of credit).

The biggest growth opportunities for on-chain lending products lie in markets that cannot be effectively covered by traditional banks, such as:

1. Personal lending market: In recent years, the share of non-traditional lenders in the personal low-mortgage market has continued to increase, especially among low- and middle-income groups. On-chain lending can serve as a natural extension of this trend, offering consumers more competitive lending rates.

2. Small business financing: Large banks are often reluctant to lend to small businesses, whether for business expansion or working capital, due to the small loan amounts. On-chain lending can fill this gap and provide a more convenient and efficient funding channel.

! [From Speculation to Utility: What's Next for the On-Chain Lending Market?] ](https://img.gateio.im/social/moments-adad9a321436440c7957e29c4d743ff6)

Challenges to be solved

While these two improvements will significantly expand the potential user base for on-chain lending and support more efficient financial applications, they also introduce a new set of challenges, including:

1. Handle debt positions backed by illiquid assets

Crypto assets are traded 24/7, while other more liquid assets (e.g., stocks, bonds) are usually traded Monday to Friday, but the prices of illiquid assets (e.g., real estate, art) are updated much less frequently. The irregularity of price updates can complicate the management of debt positions, especially during periods of high market volatility.

2. Liquidation of physical collateral assets

While the ownership of physical assets can be mapped on-chain in a tokenized way, the liquidation process is far more complex than on-chain assets. For example, in the case of tokenized real estate, the asset owner may refuse to vacate the property and may even need to go through legal proceedings to carry out liquidation.

Given that on-chain lending protocols (and individual lenders) cannot handle the liquidation process directly, one solution is to sell the liquidation rights at a discount to a local debt collection agency, which will handle the liquidation. Such mechanisms need to be deeply integrated with the real-world legal system to ensure the viability of asset monetization.

3. Determination of risk premium

The risk of default is part of the lending business, but this risk should be reflected in the risk premium (i.e. the additional interest rate added to the risk-free rate). Particularly in the low-value mortgage space, it is critical to accurately assess the borrower's risk of default.

A variety of tools are available to estimate default risk, depending on the type of borrower:

• Individual borrowers: Proof of Web, Zero-Knowledge Proof (ZKP), and Decentralized Identity Protocol (DID) help individuals prove their credit score, income status, employment status, and more while protecting privacy.

• Corporate borrowers: By integrating mainstream accounting software and audited financial reports, businesses can prove their cash flow, balance sheet, and more on-chain. In the future, if financial data is fully on-chain, corporate financial information can be seamlessly integrated with lending agreements or third-party credit rating services to assess credit risk in a more trustless way.

4. Decentralized credit risk model

Traditional banks rely on internal user data and external publicly available data to train credit risk models to assess a borrower's probability of default. However, this data silo creates two major problems: it is difficult for new entrants to compete because they do not have access to datasets of the same size. The decentralization of data is difficult because the credit evaluation model cannot be controlled by a single entity, and user data must remain private.

Fortunately, the field of decentralized training and privacy-preserving computing is developing rapidly, and future decentralized protocols are expected to use these technologies to train credit risk models and perform inference calculations in a privacy-preserving manner, thereby achieving a fairer and more efficient credit evaluation system on-chain.

Other challenges include on-chain privacy, adjusting risk parameters as collateral pools expand, regulatory compliance, and making it easier to use borrowed proceeds for real-world utility.

Conclusion

Over the past few years, on-chain lending protocols have laid a solid foundation, but they have yet to truly reach their full potential.

The next phase of on-chain lending will be even more exciting: the protocol will gradually transition from crypto-native and speculative scenarios to more efficient and real-world relevant financial applications.

Ultimately, on-chain lending will help eliminate financial inequalities and give all businesses and individuals, regardless of location, equal access to capital. As Theia Research concludes: "Our goal is to build a financial system where net interest margins are compressed to the cost of capital".

It's going to be a goal worth fighting for!