So, I did some digging on DeFi to try to understand the appeal and relate it to the real world system it's supposed to be replacing. I found this helpful article here that "explains DeFi in three minutes.":
https://decrypt.co/resources/what-are-defi-loans-ethereum-maker-aave-explained-learn
I completely understand what is going on here, and how it works. However, after looking at about 10 of these articles, I still am left with the question of "what borrower would use this?" I can only think of one - a speculative crypto trader. It would seem that these lending contracts are setup so that they can *only* work with crypto speculation. Let me explain (from my perspective).
So, Borrower A wants to borrow some BTC (or any other crypto). Under these DeFi contracts, Borrower A has to pledge Lender B some collateral in order for Lender B to make the loan. Lender B has no idea who Borrower A is - no credit profile, no non-crypto assets, etc. So, Lender B will only accept collateral in crypto that Borrower A already has. The *only* instance I can think of this actually being beneficial would be with margin loans. I mean, why would anyone borrow money from someone else if they had to give them 150 - 200% of the *same money* as collateral in order to process the loan? Margin loans are the only circumstance I can think of.
So, Borrower A pledges 2 BTC in order to borrow 1 BTC from Lender B. The only reason why Borrower A would be doing this would be to control 3 BTC instead of 2, and to participate in any upside appreciation in BTC. This is exactly how margin loans work. So, the DeFi model only seems appropriate for speculators, from what I can tell?
The other day, I wanted a loan from the bank. They told me that they would give me a $XXX loan if I deposited $XXX with the bank. I told them that they were crazy and no sane person would do that. I still don't understand that logic from them. They had some ridiculous story where some people have to keep cash reserves at banks, and thus can't spend them so they borrow against them. This DeFi loan setup seems the same way. In the real world, it does not make any sense to borrow funds from someone when they are asking for 200% of basically asset class that you are borrowing. Again, the only time this makes sense is with margin loans.
Unless I'm missing something...
Smoking gun from that article I linked to above:
Quote:
What are the Challenges?
Borrowers are often required to over-collateralize their loans, as shown in our previous example with MakerDAO.
Most borrowers deposit 200% of what they’d like to borrow. If the price of the collateral asset starts to tank, the pool will use its circuit breaker. The rules of the pool state that they won’t lose money, so as the price falls to below 120 per cent of the loan, the pool will start liquidating the collateral to cover the loan. The borrower ends up eating the loss, but will get to keep their Bitcoin, for example.
The ability for borrowers to acquire assets quickly is the draw here. If you’re speculating that Bitcoin prices will spike upwards, as a borrower, you could make a profit and be able to pay the loan back.
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-Wayne