collateral ratio in defi

Why is the Collateral Ratio So High in DeFi?

How could a borrower have a low collateral ratio? A collateral ratio in size of 300% + is standard for the DeFi borrowing/lending. A high collateral ratio would benefit the lender because over-collateralization protects the lender’s loans. However, a low collateral ratio would increase the borrower’s ability to borrow and, therefore, the system’s usability.

This article analyses:

  • What are the current collateral ratios in DeFi protocols?
  • What would be the means to reduce the collateral ratio?
  • The SmartCredit.io approach to achieve a low collateral ratio

Here is a hint to the solution – it’s all about credit-risk management. Let’s dive into the analysis now:

Here is the current collateral ratio 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 achieve a low collateral ratio?

The collateralization approach is directly linked to the risk management framework. The key here is to combine multiple credit risk management elements, leading from one side to the smaller collateralization ratio and from the other side to better risk management. Or in other words – borrowers can borrow more on the same asset basis but with the same credit risk.

Here is the list of measures for collateralization reduction:

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).

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

Could Maker use fixed maturities?

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

Could Compound use fixed maturities?

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

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

More details about Compound are available in our blog article “Compound Review and Roadmap to the Crypto Fixed Income Markets.”

On-demand collateral requirements calculation

Some assets have a 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, 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.

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, one has to prepare for the worst-case for every loan – i.e., for the non-paying borrower and the collateral value flash crash.

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

Crypto Credit Score

DeFi systems are not using crypto credit scores for borrowers. There are no systems available, which would provide credit score data; from the other side, the DeFi systems are avoiding collecting/analyzing any user data.

However, having a crypto credit score would allow us to separate good risks from less good risks. A good risk would get a better collateral ratio and vice versa. Crypto credit score allows the users to monetize their data – a good crypto credit score, which is possible after opening up their data, would result in better borrowing conditions.

Additionally, the crypto credit score would enable a diversified approach to collateral handling. In the case of good crypto credit scores, one doesn’t need to rush into the collateral liquidation during the flash crashes. However, in case of a bad crypto credit score or not opening up his data, one would need to liquidate the collateral during a flash crash.

Legal contracts and the NPL process

In traditional finance, we have legal contracts. If the debtor fails to meet his obligations, then the NPL (Non-Performing Loan process) will be started. Usually, the loan originator will sell the debt to the debt collection agencies, which pay 5% – 20% of 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 they should not follow. However, as KYC is the law in practically all countries, we can forecast that most of the DeFi products start to use KYC.

SmartCredit.io approach to low collateral ratio

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

SmartCredit.io approach and collateralization ratio
Collateral ratio comparisons

The low collateral ratio is achieved via:

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

The low collateral ratio means the borrower can borrow more against his collateral, i.e., he will increase his capability to borrow.

Capability to Borrow (collateralization ratio)
Capability to Borrow

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

SmartCredit.io ecosystem
SmartCredit.io ecosystem

Summary

The respective business models drive current high collateral ratios. If we adjust these business models, then the outcome might be better collateral ratios for the borrowers.

This results in the borrower’s increased capability to borrow. As the crypto lending market has a lot of loan supply but less loan demand, this will give a competitive advantage to the platforms with a low collateral ratio.

Further Reading

SmartCredit.io Application

SmartCredit.io Self-Reinforcing Crypto Lending Ecosystem
Why are DAI and USDC lending rates in Defi at 10%?
Can the DeFi scale to real finance? What is missing?
Why DeFi liquidity pooling has regulatory risk? What is the alternative?

Why Borrowers need Low Collateral Ratio?
Are Crypto Lending Platforms Safe?
bZx got hacked – What’s the solution?
Top Crypto Lending Platforms for Fixed Income (Guide)
Compound Finance Review and Crypto Fixed Income

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