As defi grows, it risks embracing the very ideology it was created to oppose, because the primary beneficiaries of this new financing paradigm are those who already own digital assets.

Replacing Intermediaries Doesn’t Directly Improve Finance

When it comes to financial products and services, almost everything has a catch, whether it’s high returns on investments or low financing rates. Defi (decentralized finance) is no exception.

Defi has grown in popularity because it sought to eliminate traditional finance’s (tradfi’s) inherent problems and drawbacks. While there is no denying that the emergence of defi has lowered access barriers to financial solutions, we cannot ignore the unsettling reality that defi is becoming, at least to some extent, the same as traditional finance, albeit with a ‘decentralized’ label.

The Distinction Between Defi and Tradfi Lending

Anyone who wants to borrow money from a bank or a private lender in the traditional system must provide their credit score. If the score meets the requirements, the loan is approved at a reasonable interest rate. If the borrower’s credit score is low, he or she may have to settle for higher interest rates. In some cases, the lender may also require the borrower to post collateral as collateral for the loan.

While defi replaces central authorities with a peer-to-peer system, accessing products such as defi lending requires borrowers to post substantial collateral, which is often greater than the total amount they want to borrow, a practice known as over-collateralization. Furthermore, entering the defi market and using its financial products necessitates knowledge of blockchain technology and cryptocurrencies, which only a small percentage of the global population possesses.

Defi lending began with the goal of facilitating “true decentralized lending,” in which anyone in need of capital could obtain a loan without the use of a middleman. Unfortunately, that is not the case with today’s defi lending. It has effectively evolved into yet another mechanism for existing digital asset holders to generate yields by putting their existing assets to work. Today’s defi does not empower the world’s unbanked.

As a result, it appears that defi is more lender-focused and not as all-inclusive as advertised. Take, for example, the recent parabolic growth of the defi lending ecosystem. The top defi lending platforms and protocols have amassed a total value locked (TVL) of more than $60 billion.

AAVE, an open-source and non-custodial lending and borrowing protocol, has nearly $20.96 billion TVL spread across Avalanche, Ethereum, and Polygon staking and liquidity pools. Similarly, at the time of writing, Maker DAO has a TVL of $17.06 billion and rising, Compound has a TVL of $11.33 billion, and Instadapp has a TVL of approximately $12.17 billion, highlighting the meteoric growth of defi in general.

The distinctions between tradfi and defi are becoming increasingly blurred. Here’s an example.

A small business owner from a developing country requires funding. Regrettably, they lack access to traditional financial services. They stumble upon defi lending and open an account on one of the existing platforms. When they apply for funding, they realize the collateral requirements are higher than they want to borrow, which they obviously do not have.

We must also consider the defi lending platform’s point of view. To protect lenders’ investments, defi lending platforms, understandably, require collateral. Does it, however, justify the need for overcollateralized loans? For the time being, defi is not bringing unbanked people into the system, but rather rewarding privileged crypto holders with a return on their existing assets.

Non-collateralized Defi Lending: Great in Theory, but There Are Drawbacks

Except for Gluwa, an alternative financial system for the unbanked, there are no non-collateralized defi lending platforms (that I could find). In emerging markets, Gluwa has collaborated with a number of international companies, including Aella, Multis, Creditcoin, Jenfi, Wyre, Gopax, and Consensys. Its integration with Aella’s consumer credit app reached over two million African customers. To date, Gluwa and Aella have facilitated over a million transactions, resulting in the creation of over 28 million blocks.

Users are not required to post collateral on Gluwa. However, there is a catch. The interest rate on these non-collateralized loans is significantly higher than the interest rate on collateralized defi loans available through AAVE, Compound, and similar platforms.

As a result, Gluwa, while a defi solution, shares many characteristics with the traditional lending-borrowing paradigm, such as private non-collateralized lending, in which the lender takes on high-risk borrowers and passes this risk on to the borrower in the form of higher interest rates.

The Way Forward

There’s a lot to think about when it comes to defi loans, with over-collateralized ones and high-interest non-collateralized ones. While platforms require collateral, they do make it simple for anyone to obtain capital with the click of a button. However, this is only available to those who already own digital assets. It contradicts the notions of inclusivity and equal opportunity for all, which are fundamental to defi. The flip side of the defi coin is that non-collateralized loans charge higher interest rates to compensate for the risk, which undermines defi’s vision of fair and justified earning for all.

It is difficult to achieve a truly decentralized lending and borrowing process that balances risk and return equally for both lenders and borrowers. So, in the future, we may see a better version of decentralized lending, or we may end up with “truly” decentralized lending that closely resembles the traditional financial market, thus returning full circle and becoming the very thing it sought to change.

Source: Bitcoin News