As a prime example of new DeFi lending functionality, there’s something called a flash loan that is becoming common in crypto systems.
First, we saw cryptocurrency emerge in the financial world as a series of payment media or investment assets. Bitcoin and other names became familiar, not just to hedge fund managers, but to the average person on the street, as we saw firsthand what crypto can do.
Then, those who were holding these assets started to think about how to make them grow in the same ways that traditional money does. Eventually, the cryptocurrency world developed its own credit and lending systems. Many of them are still in their infancy, but seek to bring new kinds of modern lending functionality to decentralized finance assets like coins and tokens. And in many cases, they offer much better gains than depositor offers with low-interest rates, partly caused by the actions of central banks.
The Liquidity Game
One way that experts talk about cryptocurrency and DeFi credit systems is that asset owners are on the hunt for systems that offer capital efficiency. That metric, they say, is more important than total value locked or TVL. It contemplates the return on investment in a specific way.
In general, these systems also seek to provide better liquidity – ways for asset holders and other stakeholders to move money around to grow capital. Professionals talk about arbitrage, or about ‘lossless farming’ that mitigates some of the fundamental problems with trying to grow your capital that way.
All of this promotes the development of new crypto lending and credit tools that will be part of this brave new world of digital asset management. What do they look like?
An Example – Flash Loans
As a prime example of new DeFi lending functionality, there’s something called a flash loan that is becoming common in crypto systems. These loan options are not like the traditional “short term” lending options in the fiat world, many of which have been associated with a kind of usury. These flash loans are made possible by the blockchain.
What is it? A flash loan is typically developed to be paid back in the space of one transaction block. For Bitcoin, a transaction block timeline is every 10 minutes. For other blockchains, it’s different. But the idea is that the cryptocurrency asset and its blockchain can offer the game-changing ability to generate an un-collateralized quick loan that takes no time to generate and accept, and not much time to repay.
So new systems are building in flash loan functionality and protections against “flash loan attacks” that take advantage of the speed of transactions to try to fraudulently pirate and plunder systems.
Barriers to DeFi Lending
Although this area of the finance sector is expanding quickly and evolving in interesting ways, some barriers still apply.
First, there is the assertive, some would say aggressive, the action of regulators like the US Securities and Exchange Commission. The SEC is quick to label DeFi lending products as “securities,” and go after platform operators. That has led companies to shutter more than a few decentralized finance lending proposals and programs due to fear of enforcement and prosecution.
There’s also the search for easy-to-use systems that will expand liquidity in ways that asset holders can understand and take advantage of.
Some of these systems are bringing quite a bit of new design to crypto credit and the rating of borrowers.
For example, the Soda Protocol Platform is made to work with the entity’s Sol ID Credit Rating system and enables users to stake Soda tokens to, as the company says, “generate liquidity rewards,” or in other words, make their assets work for them. This process makes use of the Solana blockchain with its unique utility for transactions.
Ease of use and scalability are key benefits of these types of systems. On-chain liquidity is in some ways the Holy Grail for investors, and capital efficiency, when realized, shows how these types of systems work to enrich asset holders more capably.
That’s the long and short of it. Today’s crypto world is advancing these types of credit and lending programs very rapidly, leveraging the idea of consensus-based verification, proof of work and proof of stake blockchain applications, and the general frictionless transaction capabilities of the blockchain ledger. It’s an exciting time for those who want to up the ante on what developing crypto chains can do, and what you can do with parked assets.
Jeff Broth is a business writer and advisor. He consulted for SMB owners and entrepreneurs for 8 years now. Jeff mainly covers finance, cyber, and emerging fintech trends.