Why are the collateralization ratios so high in DeFi Protocols?

The current collateralization ratios are ca 300% + for the DeFi borrowing/lending protocols. These ratios benefit the lenders on these platforms because over-collateralization protects their loans. However, these ratios reduce borrower’s capability to borrow and therefore the usability of the system.

This article analyses:

  1. What are the current collateralization ratios in DeFi protocols and
  2. What would be the means to reduce the collateralization ratio

Here are the current collateral ratios in key DeFi platforms:

Collateral ratios
Collateral ratios

Source: https://loanscan.io/supplied-liquidity#collateral-ratio

These ratios are rather high compared to margin borrowing requirements in traditional finance. Why is it so?

How to reduce the collateralization ratio?

The collateralization approach is directly linked to the risk management framework. The key here is to combine multiple risk management elements, which then leads from one side to the smaller collateralization ratio and from the other side to better risk management.

Here is the list of measures for collateralization reduction:

  1. Loan Maturity

On Maker and Compound platforms the borrowers do have unlimited maturities.

The platforms protect themselves with the collateral liquidation, if for example, the collateral value sinks to 135% of the loan, then the Maker will liquidate the collateral. The same with Compound (the ratios might be different).

If we would have fixed maturity loan, then we could calculate via standard deviations and loan maturity, how much collateral we should have, so that by given probability we will not hit the liquidation threshold.

Step 1: Calculate 30-day standard deviation of the underlying collateral

Step 2: For calibrating standard deviation to loan maturity we have to multiply standard deviation with the square root of “loan maturity / 30”.

By doing this we can set the amount of collateral so that the liquidation probability will be low.

But Maker and Compound do not have fixed maturities, therefore it’s not possible to calibrate loan collateral to the loan maturity. This results in very high collateral requirements, which then reduces borrower’s capability to borrow.

Could Maker use fixed maturities?

Maker DAO uses Collateral Debt Positions to create the DAI’s – borrower puts Ether into the Smart Contract (CDP) and receives the DAI’s. Having fixed maturities would imply fixed maturity CDP’s – borrowers would need to close these CDP’s before the maturity with paying in DAI’s into the CDP’s and receiving back the collateral. If the borrower forgets to pay in DAI at the right time, then the CDP would go into automated liquidation, independently from the collateral ratio.

Could Compound use fixed maturities?

Compound could introduce fixed maturities exactly in the same way as Maker. As maturities have to match on borrowing and lending side, then lenders should make fixed maturity loans as well (otherwise we get into the maturity mismatch and “bank run” risk on the platform).

Having fixed maturities would imply moving away from the “money market fund with variable interest” rate, which would be quite a change into the Compound’s business model and smart contracts.

  1. On-demand collateral requirements calculation

Some assets have lower standard deviation and their collateral requirements will be smaller. Other assets have a higher standard deviation, which leads to higher collateral requirements.

Collateralization parameters cannot be something static, which is fixed in the smart contracts, but need to be continuously re-calculated. If this is not the case, then the mitigation is to increase the collateral for any eventuality.

 

  1. Loss provisions funds

Compounds and Maker’s approach is to over-collateralize for avoiding the worst market dynamics. But the other approach would be to use Loss Provision Funds to protect against adverse market dynamics.

If one can use only over-collateralization, then one has to prepare for the worst-case for every loan – i.e. for the non-paying borrower and for the collateral value flash crash for every loan.

If one would use over-collateralization plus loss provision funds, then the over-collateralization could cover till 2-sigma events and after that, the loss provision fund would take over. The result would be increasing the borrower’s capability to borrow.

  1. Credit risk ratings

Current DeFi systems are not using credit risk ratings for the borrowers. From one side there are no systems available, which would provide this information, from the other side the DeFi systems are avoiding collecting any user data.

However, having credit risk ratings would allow us to separate good risks from less good risks. Good risks would get better collateral requirements and vice versa. Credit risk ratings would be the approach for the users to monetize their data – having good credit risk (and opening up his data) rating would result in better borrowing conditions.

Credit risk ratings would allow as well-diversified approach with the collateral handling. In case of good credit risks, one doesn’t need to rush into the collateral liquidation in flash crashes. However, in case of not good credit risk ratings or not opening up his data, one would need to liquidate the collateral during flash crashes.

 

  1. Legal contracts and the NPL process

In traditional finance we have legal contracts. If the debtor is failing to meet his obligations, then the NPL (Non-Performing Loan process) will be started. Usually, the debt will be sold to the debt collection agencies, which are paying 5% – 20% from the amount owed. Debt collection agencies continue then with the NPL process against the borrowers.

Using the NPL process would require KYC. Many DeFi products see KYC as something that should not be followed. However, as KYC is the law in practically all countries, then we can just forecast that most of DeFi products start to use KYC as well.

Reflection

Current high collateralization ratios are driven by the respective business models. If we adjust business models, then we will adjust as well the collateralization ratios and increase the usability for the borrowers via increased capability to borrow.

SmartCredit.io approach

SmartCredit.io collateral requirements are by factor 2 – 2.5 lower than the MakerDAO or Compound requirements.

SmartCredit.io approach
SmartCredit.io approach

It’s achieved via:

  1. Fixed loan maturities
  2. On-demand collateral requirements calculation
  3. Loss provision funds
  4. Credit Risk ratings
  5. Legally enforceable contracts

This results in a higher capability to borrow with equal interest rates to other platforms.

Capability to Borrow
Capability to Borrow

The lenders have unique features as well – the tokenization and transferability of their credit, which enables immediate liquidity to the lenders. And they have as well capability to define private fixed-income funds:

SmartCredit.io ecosystem
SmartCredit.io ecosystem

Reponses

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