At its core, decentralised finance (DeFi) is the use of a peer-to-peer (P2P) network through which traditional financial services can operate, free from intermediation. The hope is that this will catalyse a liberalisation of traditional finance lending, providing vital financial services to more households and firms than at present, crucially at a lower cost.
Whilst this is indeed the vision propelled by many in the crypto industry, decentralised lending platforms are currently rife with speculation and are seen by many as pyramid scheme-like enterprises used to propel rallies in crypto assets. Whilst this is far from a mischaracterisation, it misses the crucial point that as with many nascent technologies, the underlying innovation is often of far more value than its early applications.
The underlying blockchain technology affords users a number of improvements over traditional finance including:
1. Instant settlement – loans clear immediately between two network members.
2. Continuous operation – loans can be obtained on demand at any point during the day or week.
3. Security & Confidence – smart contracts ensure that both parties have the cash and collateral they claim to have before the loan is processed; hence, failed settlement is impossible.
4. Low Cost – the lack of intermediation reduces the borrowing costs and fees, allowing credit-constrained individuals to obtain funds.
5. Automation – smart contracts can automatically match borrowers and lenders and assign haircuts to collateral, removing the human element from the process.
The complex and multi-party nature of syndicated lending makes it an especially suitable application for blockchain technology. Currently, syndicated lending is plagued by inefficiencies surrounding the secure sharing of the necessary documentation between parties. This is especially an issue in syndicated lending due to the participation of: multiple lenders, one being the arranging bank; an agent bank; a trustee bank; legal advisors; and the borrower.
A network that harnesses DLT can take advantage of the benefits, discussed in previous articles, such as instantaneous updating of a decentralised ledger, accessible to all participants, on demand. The security associated with the technology also ensures that documents can be signed and made available to all parties securely and instantly. These features would considerably simplify the cumbersome process of agreeing terms and then processing the transaction through the use of a decentralised ledger.
The blockchain technology also allows for almost instantaneous settlement for a product that can take up to 20 days for settlement, drastically reducing counterparty risk faced during this window.
A consortium of banks involving BBVA, BNP Paribas and MUFG completed the first syndicated loan worth $150m on a blockchain network with Red Eléctrica, providing for the risk sharing afforded by syndication whilst taking advantage of the seamless sharing of information afforded by DLT1. This allowed for efficient communication and coordination between the three banks, the borrower and their two legal advisors.
In its current iteration, depositors provide loans directly to borrowers (P2P) collateralised by highly volatile crypto assets – the collateral value is determined by smart contract. The high level of volatility necessitates overcollateralization of the loans; hence, borrowers must either be wealthy enough to afford crypto assets or lucky enough for their crypto assets to have significantly appreciated since purchase. Other than being very self-referential, this collateral system creates an extremely pro-cyclical lending market, with lending volumes strongly correlating with the price of the underlying crypto asset.
Hence, whilst DeFi has the potential to radically alter and improve the current state of finance, it is also quite flawed in its current iteration. However, combining DeFi with widespread tokenisation2 of real-world assets has the potential to create a cheaper, more accessible form of lending to households and SMEs, representing a major opportunity for financial institutions going forward. This would remove the instability of current DeFi networks by improving collateral quality whilst retaining the benefits of the blockchain network laid out above.
Whilst such a system appears to be highly aspirational, large financial institutions have already begun implementing this model into many elements of their business. JP Morgan, Goldman Sachs and BNP Paribas have started doing just this — using tokenised Treasury Bills to conduct repurchase agreements on a decentralised blockchain network, to great success. Whilst more complicated, it is not too far of a stretch to predict that such technology could spread to the commercial and corporate banking segments of their businesses.
[1] BBVA (07-Nov 2018), “BBVA signs the world-first blockchain-based syndicated loan arrangement with Red Eléctrica Corporación”
[2] Tokenisation is the introduction of any type of asset into a blockchain network. For example, a household could tokenise their home, introduce it into the blockchain and collateralise loans with it.
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