- Traditional loans have many drawbacks, including lack of security around customer information
- While DeFi loans are still young, they are important for the development of Web3.0
- Projects are experimenting ways to perform a wider variety of loans, including using NFTs as collateral and under-collateralized loans, in order to push Web3.0 infrastructure
Web3.0 loans have the potential to transform finance.
The internet has witnessed all forms of major disruptions, going from static content to one filled with dynamic and interactive sites. Most recently, we have seen a shift to decentralized experiences.
However, people have grown weary of trust and privacy breaches, with one example being Web2.0 loans.
To get a loan from a traditional bank, many things are required – legal records, banking documents, salary slips, etc. Is it not so troublesome and complicated to get a simple loan?
Even more so, credit scores are still of major importance. Web 3.0 loans aren’t perfect, but it can definitely help to alleviate some of these issues. As such, it may be tim for an unorthodox approach, in order to challenge the reflexivity of society.
Also Read: Why Single-Sided Liquidity Could Drive DeFi 3.0
How Does Traditional Banking Work?
First, we need to understand how traditional banking works.
Traditionally, banks’ profits are earned from loans less deposits. Of course, their lending capacities are limited by capital requirements, with risk assessment playing a crucial role because they directly impact the profitability of any bank.
This is done using the Capital Adequacy Ratio Formula, which takes into account the sum of Tier 1 & Tier 2 Capital account Risk Weighted Assets.
Sounds complicated right?
Broken down, risks are measured based on human judgement, again credit scores, age, addresses, and more, which will affect how much money you can borrow. Of course, banks may also underestimate the riskiness of assets if they are too profit-driven.
Why Do We Need DeFi Loans?
The value proposition is pretty simple – it’s the groundwork for a lot of innovation in the space.
DeFi provides 24/7 open access to anyone with collateral, with no human bias. No KYC, privacy, and transparency to see what is happening to any loan in a timely manner. However, this is not to say that it is without limitations. After all, this is still nascent technology.
Web 3.0 loans also enable cross-border payments, financial services, open banking, and even payments in the Metaverse.
Cross-border payments can be incredibly troublesome when users try to send remittances abroad, with the result of having to interact with unnecessary intermediaries who may charge exorbitant fees. This is just one of the many ways centralization compromises user sovereignty and control.
The same goes with overseas loans. Getting a loan from an international bank requires compliance with local laws and regulations and so many more cumbersome factors.
In DeFi, loans can be done in a click.
Have you ever had a loan or payment taking forever to register in the system which seems to perennially never go through? That’s because your transaction is unavailable for public scrutiny since it is put through a centralized provider.
Web 3.0 will boost open banking by allowing customers to share financial information through third-party service providers via APIs.
This will help create new, innovative banking opportunities, and many banks are recognizing this in order to stay relevant to client demands.
Revenue For Customers & Institutions
Users have control over their loans and finances, and have complete data transparency over who gets their data, how long they get their data, and what they can do with that access.
Unlike traditional societies, banks use their assets in ways many don’t know. And of course, the lack of transparency means alarm bells can’t be sound in the case of recession or emergencies.
As quoted by MakerDAO, “smart contracts and cryptocurrencies highlight financial self-empowerment, with users transacting peer-to-peer around the world without the need for centralized authorities.”
Besides the decentralized aspect, according to a recent S&P Global Market Intelligence report, innovations in the traditional banking industry are based on applying modern technology to enhance outdated architecture, with the case of distributed ledger technology.
Web 3.0 allows fintech companies to lead an entirely new financial system outside the control of central authorities and reduce account suspensions and the denial of service risks, lowering the cost of server failures.
Limitations of Web3.0 Loans
DeFi and Web 3.0 are still nascent, which means that blockchain technology is still evolving, leading to many exploits but at the same time many innovative solutions materializing.
There are still the primary obstacles of crypto prices being volatile 24/7, infectious pools and the limited choice of collateral assets. When a collateral assets slumps significantly, liquidations can fail to repay and other “healthy” assets in the same pool can get infected leading to bad debt.
Euler finance solves this by dividing assets into isolation, cross and collateral tiers, but while it is a great initiative, it still falls under the underlying principle of human-assessment, which can be biased.
This has resulted in SiloFinance being created, which allows users to create money markets for any token paired with a bridge asset.
But this still has significant flaws which has resulted in vulnerability to oracle manipulation such as the Rari Fuse market exploit.
Besides just traditional collateral, an unorthodox class of NFTs cause another way of problems for money markets due to its incredible illiquidity and difficulty to evaluative the price of the NFT. This is even more so during bear markets.
A well known and perhaps more recent example would be bendDAO, which faced significant difficulty to liquidated bad loans until a recent proposal to mitigate this.
But there is still hope as the NFT hype cools and shady projects eventually die off. For example, centrifuge is on-boarding real-world assets to DeFi as collateral in the form of an NFT.
This brings about many new opportunities, acting as a Web 2.5 product bridging real-world assets and crypto assets. Still, legitimization of NFTs as a placeholder of real-world assets can remain a problem.
Global regulators have significant work to do as Web 3.0 arrives. Policymakers are scratching their heads on how the market will take shape.
That being said, I’d rather trust code rather than human judgement for financial services (including myself as after – all we are all human) and as this is a relatively nascent industry, there are tons of malicious intentions and behaviors, with new exploits and opportunities coming every day.
The cycle of change is undoubtedly constant, and digitalization has accelerated this innovative growth.
Also Read: A Deep Dive Into Uniswap Fee Switching And How Liquidity Providers Could See A 17% Pay Cut
[Editor’s Note: This article does not represent financial advice. Please do your own research before investing.]
Featured Image Credit: ChainDebrief