Financial systems revolve around the ability to lend & borrow efficiently. Hence, credit market protocols are a crucial component of Defi. There are many talks about how the current on-chain financial system (Defi) can replace traditional finance (hereafter tradfi). Though, some problems bottle-neck the mass adoption. The heart of a lending-borrowing protocol is its liquidity pool. Lenders supply assets to fill up this liquidity pool. Assets in this liquidity pool are lent out to borrowers to earn yields. These yields are distributed to the lenders.
The current Defi credit market is hinged on an over-collateralized system (Collateral value > Debt value). Although existing solutions provide un(der)collateralized lending, they come with security measures such as KYC and credit checks which don’t justify the term decentralized. The key reason behind such a system is to minimize the risk of borrowers not paying back loans (hereafter default risk). This risk is amplified in an anonymous world like web3.
An over-collateralized system seems to be a potential solution but has some associated problems. Let’s discuss the major ones. Firstly, it only addresses a handful of use cases of borrowing, such as, It helps users meet immediate cash needs without selling their assets. Allows users to invest in market opportunities, using their existing portfolio as collateral.
Secondly, it promotes capital inefficiency. Defi is a market with many people who want to lend and earn yields and a relatively less number of people who want to borrow. On average, the capital efficiency of current over-collateralized solutions is 40%; this means that 60% of assets are sitting in the pool, doing nothing.