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A Guide to Undercollateralized Loans in DeFi

The DeFi space releases innovative financial tools almost every month. The latest one on this list should enable users to loan assets with lower value collateral. Through undercollateralized loans, borrowers would access funds way above their holdings. Also, lenders would earn interest, and lending protocols would surpass traditional banks in approachable crediting services.

As you can see, this feature should keep everyone happy. It all sounds just too good to be true. After all, under collateralization should be the next step in decentralized finance.

But is that possible? And, how would undercollateralized loans work? Read on to find out!

What Are Undercollateralized Crypto Loans?

An undercollateralized loan in crypto is a fantastic chance for investors to access substantial credit without collateral. It may sound risky for the lender, but new DeFi services should make the entire process safer for all participants.

The best way to grasp the definition of undercollateralized loans is by explaining collateralized loans.

Like loans in traditional finance, collateralized loans in DeFi work as long as the borrower provides security. This way, the lender can always get something in return if the debtor cannot pay back his loan. Generally, the borrowing party must provide at least 1.5–3x of the loan as collateral to access the credit.

DeFi collateralized loans help investors exchange crypto assets in a risk-free environment. Therefore, both parties can use a financial instrument that migrates from centralized finance into the decentralized space.

How do undercollateralized loans in cryptocurrency work?

Now, undercollateralized loans do not require borrowers to provide collateral equal to or larger in value than the loan. Instead, they can use minimum or zero asset leverage to access the funds. And they do so through credit delegation.

Here’s a hypothetical example of how credit delegation works!

Let’s say that Bob deposits $50,000 in a DeFi lending platform that provides undercollateralized loans. Next, Alice needs to borrow the same amount. However, she has very few or no assets to offer as collateral. So, how can she access the credit?

Well, Bob trusts, and maybe he even knows who Alice is. So, he delegates the credit to her. Now, Alice owns assets to the DeFi platform. And, whenever she makes payments to it, Bob gets his money back with additional interest.

This is just a simple example of how one kind of undercollateralized lending can work. Several types of undercollateralized loans exist in DeFi. We’ll go through them below. Now, let’s see how decentralized finance can support asset borrowings with lower value collaterals.

How DeFi Supports Loans with Minimum Collaterals

Decentralized finance (DeFi) is a rapidly expanding ecosystem of financial instruments and services. Contrary to the traditional centralized finance (CeFi), DeFi provides numerous tools that generate wealth and growth. Most importantly, almost anyone can use them without previous investment experience or colossal funds.

Through DeFi, people from all over the world can improve their financial situations. This means that even those without access to banking services can make money starting from scratch. Lastly, they don’t need approval from bankers, brokers, or other centralized institutions to invest and trade as they please.

The undercollateralized loan is among the latest financial tools in DeFi. It should enable people to access funds even if they don’t have enough assets as collateral. Above all, it should grow on beneficial DeFi features, such as:

  • The security of immutable blockchain technology
  • Global availability
  • Access without restricting eligibility standards
  • Free from the control of centralized authorities
  • Full asset management
  • Peer-to-Peer (P2P) loans

Additionally, DeFi enables quick and effective lending and borrowing at low-interest rates. This means that users could borrow funds for countless reasons regardless of their income or background. And, here is where uncollateralized loans become decisive.

The possibility to loan funds with low or zero collateral should attract more people to DeFi. In return, this should create a spiral effect where the ecosystem expands to make even more financial tools. And in time, decentralized finance may have more users and beneficiaries than the centralized system.

Types of Undercollateralized Loans

From the start, we should mention that DeFi has produced several types of undercollateralized loans. Each of them comes with different features. However, all abide by the same principle, enabling borrowers access to funds with minimum collateral.

At the moment, we can divide undercollateralized loans into eight kinds:

  1. Flash Loans
  2. Third-party Risk Assessment
  3. Crypto Native Credit Scores
  4. Off-chain Credit Integration
  5. Personal Network Bootstrap
  6. Real-world Asset Loans
  7. NFTs as Collateral
  8. Digital Asset Loans

Let’s break them down and see how they work!

1. Flash Loans

One of the oldest forms of undercollateralized loans in the crypto industry is flash loans. This practice involves borrowing and repaying the loan within the same transaction. Since both have to complete simultaneously, the risk of default is non-existent.

Flash loans are ideal for arbitragers looking to profit from the price fluctuations between two crypto exchanges. Additionally, they can help with collateral swaps and liquidations.

On the other hand, a flash loan is the least suitable form of borrowing for personal purposes. Instant repayment means that the margin between the loan and the collateral is significantly slim.

Some DeFi protocols that support flash loans include Aave, Uniswap, DeFi Saver, Equalizer, and Furucombo.

2. Third-party Risk Assessment

One of the most exciting types of undercollateralized loans adds a third party between lenders and borrowers. Simply put, before any asset changes hands, a high liquidity holder vouches for the debtor. In case of default, the third party lose a part or all of the assets they used for collateral.

This practice enables loaners to access funds without using anything for collateral. Instead, they must ensure that the third parties participating in the transaction trust them entirely.

The best part about third-party risk assessment is that it enables under-collateralization for personal loans. Additionally, it opens the door to microfinance and decentralized prime brokerage.

The downside is that most DeFi protocols will need a substantial number of wealthy liquidity holders. Otherwise, they may lack the funds to support significant undercollateralized loans.

Some DeFi protocols that support third-party risk assessment include Maple, Dharma, Truefi, Goldfinch, and Bloom.

3. Crypto Native Credit Scores

This type of undercollateralized loan aims to leverage the users’ history on the blockchain to determine their repayment abilities.

For instance, a DeFi protocol may look into a user’s historical loan repayment, yield farming, or trading activity. Depending on this information, it can identify the funds they can use as collateral for a loan.

Since blockchain records and updates all its data, this practice can work on several levels. However, to do so, it requires that users reveal more details about their identities. Unfortunately, this would contradict the blockchain’s principle of anonymity.

The solution may come from zero-knowledge-proof protocols. And, some of the projects working in this direction include Ledgerscore, Wing, and Zoracles.

4. Off-chain Credit Integration

Some protocols aim to import off-chain data to help support undercollateralized loans. This way, they can dribble the age-old problem of revealing on-chain identities. However, it may not provide long-term usability and practicability. That’s why for now, only Teller is looking into adopting this solution.

5. Personal Network Bootstrap

In this case, protocols would restrict public access to the lending pool. For instance, borrowers would require an invite to enter the section and ask for a loan. As a result, the level of trust increases considerably and depends solely on the lenders.

Some of the protocols approaching this solution for undercollateralized loans include Aave, Union, and Akropolis.

6. Real World Asset Loans

This solution seeks to use real-world assets as NFTs on the blockchain. These assets would act as collateral for loans. While it is still in its early days, this practice may soon face the challenge of sparse liquidity. After all, protocols would have to prepare funds for the most audaciously expensive authentic world goods.

Centrifuge and Open Dao are among the few protocols looking to implement this service.

7. NFTs as Collateral

Another way to support undercollateralized loans is through blockchain NFTs. The market for non-fungible tokens is rapidly growing. With an increase in size and demand, protocols supporting this idea could have access to almost limitless liquidity. Unfortunately, that may collapse as soon as the NFT sector takes a popularity hit.

Aave, Helio, and Lendroid are among the protocols looking to bank on the NFT craze and incorporate them into their lending services.

8. Digital Asset Loans

This solution for undercollateralized loans comes from the Lendefi protocol. In this case, the project holds custody of the collateral until the borrower repays its loan. This way, if the borrower cannot pay back the funds, the contract liquidates the position and covers the loss.

Conclusion – Are Undercollateralized Loans the Future of DeFi?

At the moment, it is clear we’re living the early days of undercollateralized loans. Decentralized finance has proven again and again its ideal support for unconventional innovations. Therefore, we wouldn’t rush ahead when claiming that this service could one day be at the center of DeFi.

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Nevertheless, DeFi lending protocols have a long way to go before becoming the go-to solutions for lenders and borrowers. Only mainstream DeFi adoption can help them overcome traditional banking services in one of the oldest human practices, lending money.

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