DeFi Lending: Intermediation without Information?

Updated: Jun 20, 2022

In a new report, published 14 June, entitled “DeFi lending: intermediation without information?”, the Bank for International Settlements puts the spotlight on DeFi and the limitations of anonymous borrowing, lending and trading.

What’s Wrong with DeFi?

While the report acknowledges the “genuine innovation” that DeFi offers, and the advantages of the automation and streamlining of financial processes, it is highly critical of aspects of its current implementations namely:

Anonymity /Inefficient use of capital Market participants in DeFi are anonymous. Risk assessment of the borrower, traditionally carried out by financial intermediaries, is therefore not possible. DeFi uses over-collateralisation of loans to mitigate this risk which leads to an inefficient use of capital. Pro-cyclicality in DeFi lending Only assets recorded on blockchains can be borrowed or pledged in DeFi, which makes the system largely self-referential. This leads to pro-cyclicality on DeFi lending.

In booms, appreciating prices mean that collateral values increase, while collateralisation ratios fall. In turn, borrowing constraints relax and loan volumes expand, feeding into further price appreciation and boosting volumes. In busts, however, loans are liquidated as prices – and hence collateral values – decline sharply, suppressing lending activity.

Lack of Connection to Real World

As DeFi loans are disbursed in cryptoassets and secured by crypto collateral, they do not currently finance real economy activities. The volatility of the digital assets being utilised can mean significant losses for those involved as has been recently witnessed.

The Case for Permissioned DeFi?

While, as stated, the report is highly critical of the perceived shortcomings of DeFi, it concludes by outlining the ways in which the real benefits promised by the technology can be realised - both of which involve greater centralisation.

Large scale tokenisation DeFi lending must engage in large-scale tokenisation of real-world assets, unless it wants to remain a self-referential system fuelled by speculation. Representing assets such as buildings or capital equipment on the blockchain, so that it can serve as collateral underpinning loans, would be particularly beneficial for SMEs, which have more limited access to finance.

Abandon anonymity

Identifying who is involved in transactions enables more effective use of capital and regulation of the space.

While it did not specifically mention the term, BIS is, in essence, calling for Permissioned DeFi, also known as Institutional DeFi.