Efficiency in DeFi with Dynamic Collateralized Lending

The rapid evolution of decentralized finance (DeFi) has brought about numerous innovations, yet one of the key missing pieces has been efficient and scalable credit markets. As DeFi continues to mature, the integration of credit scores on-chain is poised to change that. Alongside partners, Credora is working towards dynamic collateralized lending applications. We believe this innovation will help unlock significant utility for crypto-native participants.

Introducing Dynamic Collateralized Lending Markets

Currently, the market offers two ends of the collateralized lending spectrum; overcollateralized or unsecured. This ignores a large middle ground, excluding borrowers willing to pay a premium to improve capital efficiency, as well as lenders who view the relative risk reward as attractive.

Dynamic collateralized lending markets combine the strengths of overcollateralized and undercollateralized lending. In nearly all DeFi lending protocols, overcollateralization is the pillar of risk mitigation, where borrowers deposit collateral that materially exceeds the value of the loan. While this provides security and a level playing field for all borrowers, this model can be inefficient and unappealing for larger creditworthy firms. It also constrains yields by limiting capital utilization. In other words, supply across major overcollateralized lending protocols materially exceeds demand.

The natural demand for borrowing in a significantly overcollateralized manner is limited to a particular audience. This is compounded by the fact that in order to have on-demand liquidity for lenders, protocols rightfully manage towards underutilization of the pool (e.g. Aave optimal utilization for USDC is 92%). The result is a large spread between the borrowing interest rate and the lending interest rate. Given the average yield on stablecoins in these pools tends to be similar to treasury yields, a higher sustainable yield can attract additional capital.

The following table presents snapshots of utilization across Compound and Aave (8/14/24), on the Ethereum Network:

*Compound is currently incentivizing activity by distributing COMP rewards, which naturally increases utilization. The Borrow Rate and Lend Rate presented ignore COMP rewards.

Dynamic collateralized lending markets leverage credit information on borrowers to offer more flexible lending terms, allowing borrowers with strong credit assessments to access higher Loan-to-Value (LTV) ratios, albeit at a premium in interest rate. This approach can significantly enhance capital efficiency, enabling qualified borrowers to more effectively access large capital markets. It allows lenders to go further out the risk curve in a quantifiable way while limiting downside, driving sustainably higher yields.

Making some simple assumptions, we can explore the potential efficiency impact where LTV ratios are modified for creditworthy borrowers. Consider initial protocol stablecoin metrics as follows:

• Active Supply: $1.5bn
• Active Borrow: $1.0bn
• Utilization: 67%
• Optimal Utilization: 92%
• Borrow Rate: 5%
• Lend Rate: 3.33% (no protocol fees)

The table below represents scenarios where creditworthy borrowers are capable of borrowing the idle $380m of capital at an improved LTV (e.g. 90%) to take utilization closer to optimal levels. From an interest rate perspective, it is reasonable to assume an increase in the marginal demand, and the table assumes that borrowers would pay a 20% premium on the interest rate.

The example is simplified to demonstrate the core concept where flexibility in the underlying parameters for creditworthy borrowers drives marginal demand, improves utilization, and increases lender interest rates. In practice, specific parameter setting will rely on a collaborative modeling approach.

The Role of Credora’s On-Chain Credit Scores

Credora’s on-chain credit metrics offer a way for dynamic collateralized lending markets to exist in a programmatic way, maintaining the current user experience and ethos offered by the likes of Morpho, Aave, Compound, and other protocols. By providing a transparent, dynamic assessment of a borrower’s creditworthiness, Credora allows DeFi protocols to explore a wider range of lending terms and optimize utilization. The following is a summary of how Credora’s credit scores can unlock utility in dynamic collateralized lending applications:

Dynamic Loan Terms: Utilizing Credora’s credit scores, DeFi protocols can offer varying loan terms based on the borrower’s credit profile. Borrowers who have higher credit scores can enjoy better LTV ratios and more flexible liquidation thresholds, paying a higher interest rate in return. This has the potential to attract more borrowers while maintaining high standards for risk management.

Enhanced Capital Efficiency: By allowing for higher LTV ratios for creditworthy borrowers, dynamic collateralized lending markets reduce the amount of collateral needed to secure loans. Traders can leverage their assets more effectively, driving growth and innovation in the DeFi space.

Sustainably Higher Yields: Allowing creditworthy borrowers varying terms drives higher utilization. This aims to allow protocols to offer sustainably higher yields in a risk-managed way, minimizing the current reliance on incentives and rewards to attract capital.

Risk Mitigation: Even with higher LTV ratios, the presence of a robust credit monitoring system ensures that the overall risk is managed. Credora’s credit assessments are backed by real-time data and privacy-preserving technology, providing a reliable measure of creditworthiness that helps mitigate default risks.

Legal Recourse and Recovery: Credora can work with protocols to embed legal contracts in the on-chain score distribution, enabling efficient recovery processes in the event of any bad debt. This ensures that lenders have a clear path to reclaim funds, and enables the creation of insurance products which can further secure the lending ecosystem.

What’s Next?

More Markets is a recently announced Credora partner. The protocol is built on top of Morpho, and leverages its composable nature to create a dynamic collateralized offering. A future blog post from the More Markets team will reveal more details about the specific dynamics of the protocol.

The integration of Credora’s on-chain credit scores into dynamic collateralized lending applications marks a significant advancement in DeFi. By enabling more flexible and efficient use of collateral, these innovations drive greater capital efficiency for crypto-native participants, and can greatly expand the already significant TVL in DeFi lending protocols. The result is a more dynamic, transparent, and scalable on-chain lending market.