3 things the crypto industry needs to offer to truly integrate with TradFi
Despite the rapid growth and innovation in DeFi products, the crypto loan market is still limited to token-backed loans only, i.e. pledging one cryptocurrency as collateral for a loan from another cryptocurrency. Total Blocked Value (TVL) in the DeFi sector across all networks increased from $ 18 billion in early 2021 to $ 240 billion in January 2022. With so much liquidity in the ecosystem, cryptocurrency lending space has also grown significantly, from $ 60 million at the beginning 2021 to over $ 400 million by January 2022.
If the crypto economy is to grow to a size that is compatible with any real economy, it will need to reach the masses of retail consumers and be able to provide them with financing options.
There are several platforms such as Nexo and Genesis that offer NFT secured loans, but the service is mainly intended for blue chip NFT institutional clients. For the retail masses, there is nothing more than just token secured loans.
Here are the basic elements that must be developed before a crypto banking infrastructure can compete with banks.
A variety of goods and services
One of the most frequently asked questions from someone who is new and looking to get into the crypto economy is – what can I buy? There is nothing in the current infrastructure but NFT, DeFi products, betting and liquidity.
In a traditional economy, currencies exist because the exchange of goods for services, or vice versa, generally does not have a 1: 1 ratio, so currencies serve to facilitate the transaction of goods and services. In a crypto economy, currencies exist before goods and services are made widely available to consumers. This makes cryptocurrencies difficult to evaluate and volatile.
A healthy and functional banking system also depends on a sufficient supply of liquidity from customer deposits and a sufficient demand from customers for loans. With more digital goods and services, especially non-financial ones such as art, music, real estate, or metaverse gaming equipment, the banking system will be able to use them as collateral to provide a variety of secured loans. As with car loans or mortgage loans, consumers in the crypto world will be able to own these products by paying periodically in the future.
An economy must have enough goods and services available to create sufficient supply and demand for consumers to use currencies to exchange for these goods and services. With only NFT and DeFi financial products in the current crypto ecosystem, it is very difficult to attract ordinary Joe or Jane into the economy because they just don’t have much to consume.
Reliable credit scoring system
In the current crypto loan market, no credit check system or credit rating system is needed for customers to borrow any cryptocurrency. This is because the loan is over-collateralised with a closely monitored loan-to-value (LTV) ratio. As soon as the LTV exceeds the LTV liquidation threshold, the collateral will be sold at a discount to recover the loan. The value of the collateral is never fully used and a large buffer is always reserved in the event of a sudden depreciation of the collateral value.
In traditional banking, customers have a credit score based on their past transactional behavior and financial condition, i.e. annual income, savings, loan payments and investments. In the crypto loan market, this is almost impossible as wallets are created anonymously and anyone can create as many wallets as they want. This makes it very difficult to track transactional behavior and build creditworthiness.
For the current structure to change, users should be encouraged to build a good history of all portfolio activities and loyalty to the portfolio. There are ratings like the LUNAtic Rankings for Terra that rate orders within a particular chain, but there seems to be no credit specific scoring to gauge the financial health of the order book owners.
As more and more jobs are created in the cryptocurrency space and more people are paid in cryptocurrencies, wallets that show a long, healthy history of activities such as a steady income in the form of cash inflow, a continuous stable balance or regular cryptocurrency repayments should be rewarded. The reward may be access to larger loans at lower interest rates; or access to long-term loans; or even in the form of management token dumps.
A strong credit rating system would benefit both the lender and the borrower. Lenders can earn more fees with less risk by lending more loans to trustworthy borrowers; borrowers may have access to lower interest rates, long-term loans, and other potential benefits. Most importantly, a credit rating system can help create a more transparent and healthy crypto loan market and attract more consumers to the ecosystem.
Given the highly volatile nature of cryptocurrencies (at least for now), the value of collateral should be assessed much more frequently than with a traditional secured loan. Unlike traditional collateral such as cars or houses, whose values are more predictable and don’t change radically over a short period of time, collateral in the cryptocurrency world, such as NFT or cryptocurrency trading, can face sudden downward movements in just one day. Therefore, it is very important that lending platforms have robust collateral rating systems that can estimate the market value of any asset at any time.
An actively managed security rating system
Alternatively, lending platforms can create something similar to the concept of risk-weighted assets (RWA) in the banking world to give more risk weight (lower LTV liquidation thresholds) to more risky and less secure collateral, so they do not necessarily have a high frequency collateral rating system.
It is not difficult to assess the market value of NFT or cryptocurrencies by the minute. But as more and more goods and services become available in the crypto ecosystem and more types of assets qualify as collateral, having a high-frequency security rating system can be expensive.
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