Why is it said that DeFi will consume the centralized credit market?

This article is from Ethereum enthusiasts, authors: Sid Powell, Joe Flanagan, translated by Min Min and A Jian, original title: "Opinion | DeFi Will Devour Centralized Credit Markets."

For centuries, credit markets have been one of the main driving forces of economic development. As early as 1780 BC, farmers in Mesopotamia used their farms as collateral to borrow money, thus obtaining cash flow until the next harvest (this is the earliest form of "Yield Farmer").

Source: Livescience

Today, credit has become an indispensable part of healthy financial development. We need credit to achieve long-term goals and build long-term businesses. Imagine if you were to build a factory; not only would you need to invest a lot of time, labor, and capital, but you would also have to wait a long time to turn a profit.

For small businesses, commercial loans are particularly important because they cannot issue bonds or sell stocks in the public market. Phil Knight, the founder of Nike, emphasized the importance of credit lines in the early days of Nike in his memoir "Shoe Dog." To meet market demand, Nike needed funds to cope with the continuous orders from suppliers. As Knight said, "Almost every day, I think about liquidity, I talk about liquidity, and I pray for liquidity."

If entrepreneurs cannot easily access and borrow funds, innovation will be hindered.

Unfortunately, in the DeFi industry, we still lack liquidity…

1. A Missing Lego Piece in DeFi

The lending boom in DeFi has failed to create a true credit market

In recent years, lending has been the hottest sector in the DeFi industry. In a nearly $25 billion market, lending occupies half of the space. Lending protocols like Aave and Compound allow users to earn yields by staking cryptographic assets or borrowing other assets.

However, it is well known that the current DeFi "lending protocols" have a problem. They require all loans to be over-collateralized, meaning that the user's collateral must exceed the loan amount (the collateralization ratio is usually over 120%). In this model, Compound and Aave can ensure their solvency because once a user's collateralization ratio falls below the minimum ratio set by the protocol, an automatic liquidation mechanism is triggered.

While these protocols represent significant progress for the DeFi industry, they are still insufficient to form an effective credit market.

As Jake Chervinsky from Compound stated, these protocols are clearly designed to avoid reliance on forward commitments. While this approach allows these protocols to maintain solvency and become effective sources of leverage, it also prevents them from introducing fundamental characteristics of credit markets, such as trust and reputation.

The inefficiency of such protocols is evident—borrowing $100 by staking $150 is only applicable in a few situations (which is why over-collateralized loans are not common in traditional finance).

However, this is the current state of DeFi lending, because introducing trust in an anonymous ecosystem presents significant challenges. In traditional finance, credit scoring and lender assessments require identity verification—something that is difficult to achieve in an anonymous ecosystem like DeFi.

2. How DeFi Credit Markets Can Develop to Billions of Dollars

How decentralized credit markets operate (Source: Maple Finance)

Let's take a look at the two major lending demands in the DeFi industry.

Cryptocurrency miners need credit to cover the costs of purchasing mining machines and electricity. Trading funds and market makers need credit to leverage their portfolios and supplement liquidity.

These two demands represent a lending market worth billions of dollars in the cryptocurrency industry. With decentralized credit lines based on Ethereum, lending protocols can operate more efficiently, scale their operations, and achieve rapid growth.

Participants in DeFi lending have healthy balance sheets, low-leverage portfolios, experienced asset managers, good reputations, and positive cash flows. In short, they are the most sought-after borrowers by DeFi lending protocols.

However, DeFi cannot meet their needs. As mentioned above, existing DeFi lending protocols are inefficient for lenders and are not a viable option for large enterprises genuinely seeking credit (rather than leverage).

As a result, many miners and traders are flocking to centralized lending protocols. Genesis's lending business is experiencing explosive growth, with its lending volume increasing by $5 billion in the third quarter. BlockFi is also growing at an astonishing rate.

The cryptocurrency industry clearly has a high demand for credit. According to data from centralized lending protocols, the lending market is currently worth billions of dollars, and this is just the beginning.

So, when will it be decentralized credit's turn?

3. Why Decentralized Credit Will Devour Centralized Credit?

On-chain credit shows significant improvements over centralized credit.

Decentralized credit markets greatly increase the number of lenders, creating a more competitive market. Through an open architecture, anyone globally can become a lender as long as they are willing to take on the risk. Just as anyone can become a liquidity provider on Uniswap, anyone can provide their funds to verified lending institutions and earn returns.

On-chain credit markets also greatly enhance capital efficiency because borrowers can access capital markets directly without going through "gatekeepers." In other words, they enter funding pools through open protocols rather than obtaining funds through intermediaries, thus lowering loan interest rates. Finally, borrowers can take loans from multiple lending pools, creating pricing pressure for price discovery.

Although credit markets have traditionally been opaque and institutionally dominated, decentralized credit allows both borrowers and lenders to enter the lending market in a completely transparent and equal manner.

Ethereum-based on-chain credit markets have auditable loans and liquidity reserves sufficient to assure liquidity providers that their funds will be as safe as those stored in centralized lending protocols. Additionally, the programmability of decentralized protocols opens up design space for incentive compatibility, helping to create more efficient credit markets.

For example, Maple requires entities conducting credit assessments to stake MPL tokens to avoid default risks, ensuring aligned incentives among all parties and protecting lenders.

Given the high demand for credit among users and the vast potential number of lenders, decentralized credit markets can easily surpass the $25 billion locked in DeFi.

4. Boosting DeFi

At Maple, we decided to create an on-chain credit market because we believe DeFi is an innovative industry that needs to develop credit services.

Thanks to our previous experiences in commercial lending and traditional finance, we understand the importance of credit markets for innovation. Since we entered this space and began exploring how to better drive growth, we have focused on improving capital flow and directing capital to where it can create the most value.

Although DeFi is experiencing explosive growth, it cannot reach its full potential without a well-functioning credit market. If the efficiency of the lending market in the cryptocurrency ecosystem improves, more funds can be borrowed per unit of deposit, thereby driving the development of the entire DeFi ecosystem.

Introducing decentralized credit can also allow honest participants to benefit from their good reputation in DeFi, thus reducing their borrowing costs. Finally, for those businesses blocked from access to over-collateralized loans and unable to reinvest all their funds into their operations, credit will be highly beneficial.

5. The Growth of DeFi

Creating an efficient credit market that serves professional lenders can provide liquidity providers with a more sustainable source of returns.

While "DeFidegens" enjoy arbitraging between different DeFi protocols, long-term lenders find it challenging to earn high returns. Compared to liquidity mining, lending to high-quality cryptocurrency-native entities such as funds, market makers, and miners is a more sustainable source of returns.

Currently, there are more and more DeFi products designed for long-term investors. Just like the passive DeFi token investments offered by DeFi index funds, decentralized corporate debt pools represent a significant advancement for the vast majority of investors seeking a one-stop solution.

The increasingly mature DeFi is no longer the "casino" of 2020 that made quick money. In the future, more institutions will begin to use cryptocurrency-native products. Therefore, it is not hard to imagine that in the short term, the main participants in decentralized credit markets will be cryptocurrency-native enterprises. However, its potential impact and application scope extend far beyond this.

Just as Bitcoin has become a reserve asset for enterprises, components of DeFi such as decentralized credit markets will also enter traditional finance. It is only a matter of time. Another billion-dollar market is about to be born.