Check out the first two episodes of Season 1 on youtube!

Where does cryptocurrency come from? with Andy Tudhope

OS Systems and dGov with Jordan Ellis

Will keep these youtube episodes coming! It’s been fun to revisit these conversations with such knowledgable people.

Below are thoughts developed from working at Maple.Finance… this essay summarizes the way undercollateralized Defi systems break the traditional metric of Total Value Locked (TVL) for the industry. Let us know what you think!

~ JD

Undercollateralized lending will force Defi to rethink common success metrics.

Capital efficiency is an unsolved problem in the world of decentralized finance. Companies taking crypto loans today either rely on centralized OTC desks like Gemini or Coinbase, or use more capital intensive trustless protocols like Aave and Compound. Non-custodial undercollateralized lending does not exist in the ecosystem due to inherent risk of defaults and lack of intelligent decision-making by smart contracts.

In Defi lending protocols today (Aave, Compound, Maker DAO, etc.) smart contracts rely on borrowers to stake collateral that will be liquidated in case of default. The amount of collateral staked supports the value lent by the system. The most common success metric used for these protocols is the Total Value Locked (TVL) of the smart contracts. TVL is greater than the outstanding loans by ~300% on average today. 

An undercollateralized system flips this capital requirement. Instead of fully securing the value of the network, undercollateralized lending grants access to loans with the trust that the borrowers will pay these loans back. In traditional finance, that trust is determined through an underwritting process that takes into account credit score, financial statements, and various other factors. Underwritting in tradfi varies between firms, jurisdictions, and industries. Well defined standards do not exist. 

So, how should we determine value of these undercollateralized lending protocols?

New metrics will need to emerge to understand the value created by undercollateralized systems. Because these systems offer trustless lending, focus should be placed on liquidity provider risk. The LPs of these undercollateralized systems are the ones with the most to lose, and they deserve to understand metrics such as Default Rate, Total Incurred Losses, Collateral to Debt Ratio, and Average APY. 

The metrics associated with undercollateralized lending will take significant time to emerge. These systems are inherently risky, but will also provide a significant increase in capital availability for the entire space. While providing liquidity may be trustless, borrowing and decision making for borrowing should take a path of trust minimization to provide as much security as possible to those risking funds. 

The metrics we use to qualify the value of these systems will look very different from the over-collateralized lending protocols we saw emerge in the first wave of decentralized finance.