Raising funds is one of the biggest issues for nascent projects across DeFi. As the competition for investors’ funds grows, it becomes a challenge for them to attract attention and get their much-needed cash flow for development — which, in its turn, stalls the creation of viable systems and products that can offer unique value to people.
Given the vastly lacking regulation in the field of cryptocurrencies and the lack of understanding of DeFi workings by banks, it would seem a rather impractical idea to take a fiat loan to, for example, build a decentralized protocol facilitating the peer-to-peer exchange of funds. In this scenario, using decentralized systems would be a more viable option.
Looking into blockchain loans
By getting a loan from a blockchain-based system, projects are able to eliminate red tape and get access to funds for product development without disclosing any sensitive data. The amount of funds accessible for a loan and the interest rate can vary depending on characteristics such as liquidity, volatility, trading volume, exchanges in which the collateralized token is listed, etc.
There are a few points to consider, though.
For one, most blockchain-issued assets (cryptocurrencies and fungible tokens) have a tendency towards large price swings, which could be detrimental for a project with a tight budget. Lending stablecoins to earn yield can be a solid option for such kinds of projects, as stablecoins’ price is immune to the fluctuations of the cryptocurrency market. Through stablecoin lending, crediting platforms can earn interest on their stablecoins while allowing the borrowing businesses to access their needed cash flow.
Second, most lending platforms only support a handful of assets as collateral, often those with the most liquidity. Therefore, only a reduced number of projects can use their own tokens as collateral to access a stablecoin loan. Even if a project has a certain amount of liquidity and trading volume associated with their token, it can still be difficult to use it to get a loan. Therefore, the market will require more lending opportunities for projects that have already raised funds and are looking for cash flow for further development of their products.
How to get a decentralized loan on a lending platform
To take a loan in stablecoins, you need to provide collateral on the lending platform. This collateral will be locked until the loan is paid back. Every token is assigned a loan-to-value ratio (LVR), which will determine how many stablecoins you can borrow: for example, a 50% LVR would mean that a borrower can take a loan in stablecoins worth half the valuation of their collateral.
Once a project takes a loan, its collateral gets locked on the lending platform. The price of the collateralized tokens will affect the LVR of the collateral, and borrowers’ demand for loans will determine the interest rate. Borrowers should be wary of the price of their collateralized tokens, as a loan can be liquidated if the collateral’s valuation drops below its liquidation threshold, resulting in the borrower losing their collateral. Lending platforms, some might be surprised to hear, do not benefit from liquidations: it is in the best interest of the platform to avoid paying network fees caused by loans becoming uncollateralized, hence the platform’s design needs to be optimal for all parties involved.
Viable financing option for businesses
Coming back to the initial question, ‘Can blockchain loans become a viable option for businesses?’ I believe it’s fair to say that the answer is yes. However, there is much-untapped growth potential in this area.
To suit the needs of businesses requiring long-term sources of capital, and engage more crypto assets in the decentralized economy, the DeFi space should introduce new mechanics and create better infrastructure, providing support for as many tokens as possible. The second course of action is to educate end-users so that projects will have a better idea of the benefits of blockchain loans — as well as the requirements for getting one. More educated users and better product design are undoubtedly the key to attracting more businesses in need of cash flow to lending/borrowing platforms.
With the ongoing adoption of cryptocurrencies and DeFi, it is all more likely that stablecoin and blockchain loans will be getting more traction in the foreseeable future. As the cryptocurrency market is looking ready to mature and high net-worth investors are becoming interested in the investment opportunities DeFi can offer, the demand from businesses for longer-term loans in stablecoins will grow.
Until then, it is our responsibility to make sure that the solutions new users find are secure and present friendly, intuitive user interfaces. DeFi’s promise is to democratize access to financial instruments, which means that we need to cater to both professional financial players and everyday users looking to transcend the traditional finance panorama.
Is this a hard promise to live up to? Yes, it is. Would I argue that this is absolutely necessary? Always.
Brian Pasfield, CTO at Fringe.fi