Cryptocurrency-based lending has emerged as an important trend in the decentralized finance (DeFi) market.
However, it faces certain challenges relating to Know Your Customer (KYC) considerations, risk management and risk pricing. This, according to a report from Huobi, which noted that these challenges can be “addressed by limiting loans to on-chain legal persons, stepping up risk management, and using a market-based mechanism for risk pricing.”
These were the findings of various blockchain research organizations.
Huobi Research Institute’s report, titled “Finding the Next Growth Engine for Crypto Lending Markets” (The latter is the first in Huobi Research Institute’s “Discovering the Unicorns of the Future” series of research reports, which will track key industry trends and provide insights on the industry outlook) notes that decentralized lending protocols have always been “an important part of DeFi.”
However, the lending business in the DeFi market has “stagnated recently due to the limited types of collateral.” The crypto lending market, which has developed rapidly in the past year, “mitigates the shortcomings of the DeFi lending market with its low threshold requirement and low costs.”
The Report includes an analysis of the crypto lending market which identifies the following development challenges:
- KYC: The anonymity of the blockchain network has “been a key factor hindering the development of the crypto lending market.” The lack of identity authentication and background checks on the borrower “contributes to a high risk of default.”
- Risk management: Compared with traditional finance, the crypto lending market lacks a track record and data, and new technical models need “to be developed to measure crypto credit risk and portfolio management.” More importantly, traditional credit implements risk management off-chain. The execution of risk management for crypto credit on-chain “is no small challenge.”
- Risk pricing: Due to the homogeneity of collateral, excess mortgages can complete interest rate pricing “in accordance with market mechanisms.” However, due to the differences in entities, the risk premium for crypto lending “will be different, and pricing will be more difficult.”
In order to strengthen the crypto lending market, Huobi Research Institute “makes the following recommendations” in the Report:
- Lending to on-chain legal persons: Limit on-chain credit loans to only two types of borrowers – “a natural person or legal person who has done KYC off-chain; and accountable corporates with substantial financial interests on-chain such as DeFi head protocols and Decentralized Autonomous Organisations (DAO).”
- Stepped-up risk management: Similar to traditional financial markets, future crypto lending markets “can take guidance from the risk management framework of the Basel Accords.” Credit risk management, credit default probability, default loss ratio and other indicators “could be calculated through internal rating and credit risk measurement models.”
- Market-based mechanism for risk pricing: With detailed rating and credit risk metrics, the market “can be given a pricing reference, and market pricing could be achieved through a Dutch auction.”
In order to offer a more complete understanding of the on-chain crypto lending model, the Report also “features an analysis of three current mainstream on-chain credit projects: TrueFi, Goldfinch and Maple.”
This includes the functions and cost-benefit considerations “of all parties involved, as well as the strengths and weaknesses of their risk management and pricing models.”
To access the complete report, check here.