If you are familiar with DeFi, you will have heard about crypto loans. Usually, these loans are collateralised. Or, in other words, guaranteed by an underlying asset.
But did you know there are also crypto loans without collateral?
Generally, crypto loans without collateral or under-collateralised crypto loans occur through a traditional credit-checking route. However, some protocols aim to assign credit scores to blockchain wallets for this purpose.
Before we get started on why under-collateralised crypto loans are so important, we must understand the limitations of over-collateralised crypto loans and why people might prefer loans without collateral.
Firstly, using crypto as collateral can be an inefficient use of capital. Instead, you could use that capital to stake or provide liquidity to the blockchain ecosystem, thereby earning rewards and strengthening the network.
Second, it is not suitable for long-term loans such as mortgages. To facilitate this, we need under-collateralised loans. Mortgages usually require 25% collateral, with the remaining 75% paid over 25 years.
How Do Crypto Loans Without Collateral Work
Crypto loans without collateral can fall into two main categories – loans to consumers or institutions. When talking about under-collateralized loans, we mean loans not backed with monetary value. Instead, borrowers use their reputation as collateral.
Undercollateralised Loans to Consumer
In crypto, loans without collateral have yet to become mainstream for consumers. But some promising projects are working on solutions.
For example, DECO is a protocol owned by Chainlink which verifies borrowers’ identities and uses zero-knowledge proofs to provide a private attestation to the blockchain. The protocol can take information such as real-world credit scores and identity, verify it and broadcast it to oracle nodes on a blockchain.
In simple terms, the network will verify users’ credit information off-chain, and they will receive an immutable certificate which they can use to access loans without collateral on chain.
Undercollateralised Loans to Institutions
Institutional investors are often able to secure loans without collateral through reputation and their equity in other crypto assets. Many of these multi-billion dollar funds were regarded as too big to fail in the past. Therefore, lenders felt large institutions were a secure and lucrative way to earn returns.
What are the issues with Under-collateralised crypto loans?
When it comes to loans without collateral for consumers, using a private, cryptographic network such as DECO means users can benefit from attaining credit without going through third-party intermediaries. It also opens the blockchain up to a massive new user base.
On the other hand, the institutional under-collateralized loans which have been prevalent over the past few years have proven disastrous for the cryptocurrency industry. These institutions go against the crypto ethos.
Irresponsible, over-leveraged and top-down decision-making has shown much of the institutional money in crypto to be a house of cards, from the 3AC collapse to the Almeda and FTX spectacle. Much of this was due to loans without collateral, resulting in significant losses for retail investors.
Crypto must offer the same products as traditional finance (TradFi), but better, to compete with it. To do this, we should fix TradFi issues, including inflation, lack of control, and discrimination. We should replace them with a permissionless and non-discriminatory blockchain solution which puts the power in the hands of the everyday user.
A P2P lending and borrowing network powered by DeFi smart contacts will help remove the need for much of the institutional crypto investment and, thus, make it a safer place.
