Cryptocurrencies like Bitcoin were originally introduced as a substitute for fiat currencies. The main idea behind cryptocurrencies is to transfer the monopolistic control of the governments and Central Banks over the monetary infrastructure. Therefore, cryptocurrency investors often use the term DeFi or decentralized finance which refers to a currency management system that is not influenced by any centralized regulator.
The most basic and central role of money is to act as a medium of exchange. People can buy different goods and services in exchange for money which represents the transfer of value. However, paperback also performs several different functions of the centralized financial system, like trading and acting as collateral. In recent years, the DeFi sector has improved itself and opened several avenues for collateralization.
What is Collateral?
Before talking about the DeFi sector, it is important to establish what is collateralization first? Collateral means a certain amount of money that a person or a party has to pledge to qualify for a loan. Many banks allow people to borrow money against collateral such as their bank account, commodities, or even bonds.
In order words, the collateral works as a warranty for the lender in case the borrower is not able to make a profit or return the borrowed amount in time. In most cases, the lenders charge an applicable percentage on their lending amount. The lenders also reserve the right to confiscate the collateral in case the borrower is unable to return the promised amount within the required time.
How Does Collateral Work?
There are several types of collateral options available in the financial sector. For each different type of collateralization, the terms and conditions are different. In countries like the USA and many others, individuals can borrow money from the regional banks that are regulated by the Central Bank. These regional banks allow the citizens to borrow for purchasing fixed assets like vehicles, houses, or expanding their businesses.
According to Investopedia.com, the lenders typically use the appraised collateral value of the pre-owned equity of the borrower to issue a loan. For the most part, a lender issues a loan that is equal to 70-90 percent of the collateral amount. In retrospect, the collateral pledge of a borrower is greater than the amount they wish to lend. On the other hand, the commercial entities also sought to borrow money for making trades which is called margin trading.
Types of Collateral in the Financial Sector
Without learning about the basic infrastructure of collateralization in the traditional financial sector, it would be more challenging to grasp the process in DeFi. Traditional or financial collateralization has two main sectors, namely retail and commercial sectors.
- Retail Collateralization
- Commercial Collateralization
Retail collateralization refers to the lending that is done by individuals. These individuals want to borrow money from the bank or any other financial enterprise to make purchases in the real estate, grow their sole-proprietorship business, or even invest in any other type of purchase activity. In most cases, the individuals do not purchase margin trading, but it is also not impossible. Based on the frequency of the borrowing in this section, here are the main types:
- Real Estate Collateralization
- Investment/ Trading Collateralization
- Shopping Credit
Real Estate Collateralization
The goal of most people is to become financially independent and purchase a house for themselves. Saving up money to buy a house can take a lot of time for a person. However, with the mortgage option, a person can make a property purchase without having to wait for years. There are also some cases where people do have the funds, but they do not wish to spend it all on buying a house or purchasing a plot, so they opt for mortgage options.
In such a case, the interested party has to contact a bank to apply for a mortgage. If they wish to borrow $1000 from the bank, the bank will use LTV or loan-to-value ratio to lend them the money. Considering the average ratio of LTV is 70%, the bank will issue around $700 for the borrower. The borrower is liable to pay the loan back in the form of monthly installments with an added percentage of interest under their mortgage agreement. The same rule applies to other fixed assets collateralizations such as vehicles etc.
Investment/ Trading Collateralization
For an individual, it is not common to draw a loan for making trades as it carries a considerable risk factor. However, in some cases, people with a good understanding of the financial markets can draw funds for investing in stocks, bonds, commodities, or the Forex market. This type of collateralization is called Margin Trading.
Margin Trading is a complex concept, and a small fluctuation of $0.1 can turn the whole account into heavy losses. However, by conducting proper research and keeping the risk window smaller, it is possible to make good money from Margin Trading. Take, for example, Mr. John, who wishes to borrow $1000 from a third party to invest in gold.
Mr. John contacts a financial lender called ABC firm to apply for the loan. The ABC firm will require Mr. John to complete the necessary documentation process and issue the requested sum. However, ABC firm will also set a collateral requirement for Mr. John at 30, 50, or 100%. It means that Mr. John must always maintain $300, $500, or $10,000 in his broker’s account at all times.
Another important condition of the investment collateral is that Mr. John must pay back the borrowed amount from ABC firm in the form of installments with an added percentage of interest. In this case, Mr. John needs to maintain the collateral amount in his brokerage account to avoid a margin call from ABC firm that would require him to pledge more funds to fill up the required amount.
Just about every salaried person has heard about credit cards these days. VISA and MasterCard are one of the biggest credit card service providers in the world. Credit cards are often used by individuals to allow them to shop for things that they are unable to pay for immediately. Credit Cards are also a type of collateralization contract that allows the users to borrow small sums for everyday purchases.
A credit card company uses information about employment status, personal assets, bank account balance, and credit score. A person needs to maintain a good credit score to be able to borrow larger amounts of money from the lenders. Credit Card companies allow people to purchase things in advance, but they come with a percentage of additional interest.
Commercial enterprises also use the option of borrowing to make investments in different ventures and make profits. For this purpose, the businesses hire experts from the financial academics sector to manage their accounts and make all the necessary arrangements. Institutions like banks, financial firms, credit unions, and others make use of commercial collateralization.
- Business Development Collateralization
- Invoice Financing
Business Development Collateralization
Both small and big businesses can borrow money from third-party lenders for the development of their organizations. Most businesses borrow money to develop their operations through construction, purchase automobiles, hire consultancies, expand their factories, purchase more office equipment, upgrade their automated systems, or even get term loans.
The term loan is a collateralization contract, where a third party agrees to lend money to a business with a considerable payable period like five years etc. During this time, the business is free to use the borrowed fund at their discretion and spend it on multiple fronts. The payable period of a Term loan cannot be changed. The borrowing business also has to pay a fixed or variable interest rate to the lender.
Invoice financing is a type of short-term loan borrowing. Some commercial organizations that provide goods or services can use the outstanding bills from their consumers or unpaid invoices as collateral. Take, for example, a shoe-manufacturing store that runs an e-commerce website name XYZ Shoes. Most consumers on the XYZ shoe website make a purchase using their credit cards.
The company was able to make $10,000 in sales in one month from its e-commerce credit card purchasers. However, the company would not be able to use the $10,000 profit immediately. Therefore, it can use the invoices as evidence to streamline its cash flow, claiming the $10,000 credit card sales as collateral that would allow XYZ Shoes to use the funds for emergencies and urgent expenditures.
What is Collateralization in DeFi?
Now that the process of collateralization has been established for traditional financing, it is easy to grasp the concept in the DeFi sector. As mentioned before, DeFi stands for decentralized finance, and thus the collateralization in DeFi is not dependent on any centralized third-party lenders like banks, financial enterprises, or individuals.
On the contrary, the process of collateralization in DeFi is automated with the help of smart contracts. Rather than going to a bank to borrow money, the applicants navigate to the open-sourced liquidity protocols in DeFi. An open-sourced liquidity protocol is a trustless network that allows the lenders to provide funds for the borrowers in one place.
When a borrower wishes to draw a loan from such a DeFi liquidity pool, they need to stake the same or greater amount of money first. Unlike centralized lending platforms, the average percentage of collateral is set between 100 to 300 percent in a DeFi liquidity pool. The main reason for this high collateral rate is the price volatility of cryptocurrencies.
For example, Ms. Jane approached MakerDao, which is a well-known liquidity pool and DeFi lender, for a $1000 loan. The collateral rate at MakerDao is set at 150%. It means that Ms. Jane needs to stake around $1500 in the liquidity pool as collateral to qualify for the loan. If Ms. Jane borrowed $1000 worth of ETH at a time when it’s supposed price was $10, and she returned the loan in May when the ETH market value dropped to $5, the lender will sustain losses. Therefore, the collateral percentages in DeFi are higher.
Advantages of Collateralization Options in DeFi
The cryptocurrency sector has been around for 12 years, and it has managed to prove its mettle as an independent investment sector. However, cryptocurrency lending is a relatively new concept for even professional financial traders. Despite the factors like high collateral ratios, more and more brokers and investment consultants are opening up to the idea of DeFi lending on account of its various advantages over TradeFi. Some of these merits are listed below:
- Credit Score Free
- Lower Interest Rates
- Lending Options
- Faster Funds
- Asset Value LTV
- A multitude of Cryptocurrency Choices
- Data Security
Credit Score Free
Traditional financial borrowing systems have layers of terms and conditions to ensure a good credit standing for a lending application approval. In comparison, DeFi lenders do not run hectic background checks for processing any borrowing applicant. Therefore, anyone from a student to a new resident can easily apply for a DeFi loan.
Lower Interest Rates
Another appealing feature of DeFi lending is that it typically requires a lesser interest percentage on collateral contracts. It means that rather than applying for a mortgage from a bank, a borrower can opt to borrow money from a DeFi liquidity pool that calls for much smaller interest rates making repayments many times easier. A borrower can get a collateral contract for as lower than 10 percent interest.
In addition to borrowing, the cryptocurrency liquidity pools allow the investors to act as a lender at the same time. The traditional financial enterprises are only one-way services that only allow individuals to borrow money and pay it back. Any investor can become an independent lender on a DeFi protocol with an interesting account and earn APY or annual percentage yields higher than 10%.
The blockchain network is often recommended for its fast transaction speed. Applying for a borrowing application is many times simpler in comparison to the hefty documentation process of centralized collateralization. Furthermore, there are relatively easier qualification and screening procedures. Due to the automation of DeFi, borrowing applications take lesser time to get processed than weeks or months in TradeFi. Once the application has been approved, the funds are also transferred fairly rapidly, taking only a few hours at most.
Asset Value LTV
In DeFi borrowing, TVL or loan-to-value ratios are closer to the underlying market value of the collateral assets. In most cases, DeFi protocols allow the borrowers to draw a loan equal to 50% of their pledged assets. However, in some DeFi markets, the LTV issues a loan as high as 90% of collateral book value.
A Multitude of Cryptocurrency Choices
With the traditional loaning options, the borrowers have limited options for borrowing, and in most cases, the borrowers opt for loans in the form of USD. At the same time, the borrowers also have to offer collateral in the form of real estate, commodities, or fiat currencies. On the other hand, for cryptocurrency lending, the borrowers can pledge other crypto coins, tokens, NFTs, stablecoins, and other crypto byproducts as collateral and also have choices to borrow funds in the form of a multitude of crypto variants.
With centralized financial lenders, every applicant must provide a painstakingly detailed documentation process. TradFi lending platforms like banks, private financial institutions, and others mandate a hefty screening process that binds the borrower to provide documented and attested proof of every aspect of their lives like national registration, residential address, educational, employment status, next of kin, credit score, taxation status, employment history and much more.
Furthermore, these platforms also prefer candidates with personal connections and warrantors, making the system unfair for many people. On the one hand, handing so much information to a centralized or private borrower can create privacy issues for the applicants. On the other hand, the borrowers not only have to wait longer periods but also make peace with the fact that TradFi borrowing does not treat all applicants equally.
Demerits of DeFi Collateralization
Even with several advantages, the process of DeFi Collateralization is not free from financial risks. Therefore, before applying for a DeFi loan, it is best to consider these important precautions and factors:
- Price Volatility
- Margin Calls
- Eligibility of Digital Currencies
- Static Crypto Funds
- Lack of Insurance
- Slow speed of Withdrawals
The prices of cryptocurrencies are often subjected to high volatility. In DeFi collateralization, both lenders and borrowers need to worry about finding the right time window to pledge their funds.
Margin calls happen when a borrower is unable to maintain the collateral ratio in their brokerage account. During a Margin call, the lender demands the borrower to increase their funds to maintain the collateral. Due to high price volatility in cryptocurrencies, Margin calls can be a hassle for those who do not monitor the market trends carefully. If a borrower fails to maintain their collateral, the lender reserves the right to sell some of their assets to maintain the threshold.
Eligibility of Digital Currencies
There are around 18,000 cryptocurrency variants in the world, as per Investopedia.com. However, most DeFi lenders accept borrowing and lending funds in a limited amount of cryptocurrencies only. If a borrower or lender is using more than one DeFi collateral platform, they might have to exchange one cryptocurrency for another to qualify, which can increase hassle, transaction fee, and additional time.
Static Crypto Funds
The cryptocurrency funds that have been pledged as collateral remain unusable for the lender until they have paid off their debt fully in addition to interest. In case the market value of a collateralized cryptocurrency drops, the borrower can suffer from losses.
Lack of Insurance
TradeFi has one advantage over DeFi lenders in that the interest accounts of the lenders are not insured. In case of factors like exchange platform going out of business, the price crash of loaned cryptocurrency, and default on payable, the lenders do not have the safety net provided by insurance coverage.
Slow Speed of Withdrawals
It is easy for the lenders to make withdrawals from their interest accounts at their discretion. However, sometimes on account of factors like lack of liquidity, protocol updates, or massive traffic on the DeFi lending platform, the request can take days which can also be very harmful on account of the cryptocurrency price volatility.
Cryptocurrency lending is a fairly new avenue in the financial markets. However, as time passes, developers and fintech experts are improving the technology to make the process more feasible and rewarding. Meanwhile, for new DeFi lenders, it is important to take the logical approach and consider both sides of the coin before lending or borrowing cryptocurrencies.
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