Interpretation of the status quo of unsecured lending, is there still room for it?

Original: Outlier Ventures Compilation: GWEI Research

Part 1: Market Situation

Introduction

Our new paper, The Open Metaverse Under Attack – Fight Back introduces many encouraging growth paths for the Web3 space. In this paper, the focus will be on specific areas with great potential. In the first quarter of 2023, the US unsecured personal loan market alone reached $21 billion, surpassing the total value locked in decentralized finance (DeFi), which was only $6.1 billion. This means that the DeFi space in general has huge growth potential, and the decentralized lending space in particular. This massive growth potential was the motivation for creating a snapshot overview of the current leading decentralized unsecured lending protocols. In this snapshot, these protocols are compared wrt. Capital adoption, token valuation, incentive impact, and marketing dominance paint a clear picture of absolute and relative market positioning.

The first part of this mini-series provides an overview of the current market situation for underlying native ERC-20 protocol tokens, while the following second part will provide a more detailed on-chain view of stakeholder token flows.

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The ability to borrow assets is the cornerstone of any financial system. While lenders get a return on idle cash, borrowers need quick access to working capital. Lending markets in the DeFi space are often over-collateralized, meaning that borrowers must deposit more collateral than the loan is worth. For example, a borrower needs to provide $10,000 in ETH as collateral for a $5,000 USDC loan. While overcollateralized loans are the norm in DeFi, unsecured loans in traditional finance are sometimes partially undercollateralized or even completely uncollateralized. This overcollateralization ensures that if the borrower defaults, the collateral can be sold to keep the lender intact. Although overcollateralized lending is safer for lenders, it is not capital efficient, thus limiting market expansion. It requires unsecured lending protocols that can access trusted credit data to estimate a borrower’s risk profile without disclosing sensitive information on the blockchain, thereby overcoming this limitation in DeFi. Oracles combined with zero-knowledge proofs are already being developed to alleviate the need for borrowers to disclose their identities to unsecured lending platforms.

However, unsecured lending is an important industry in DeFi, and its loans have a higher annual yield (APY) compared to over-collateralized lenders such as Aave and Compound, reflecting higher risk. Undersecured or unsecured loans increase the chance of default. Loan liquidation and repayment of off-chain assets and contracts may take a long time. With regard to the security of the lending pool, lenders must rely on the due diligence (DD) of the pool managers. Lenders may not be able to obtain liquidity when needed because the amount of liquidity that can be drawn from the loan pool depends on the amount of liquidity present in the pool.

Figure 1 is a high-level representation of the TrueFi example ecosystem of unsecured lending protocols. Here, lenders fund a pool of loans against which borrowers will receive loans. $TRU stakeholders are able to vote on the loan, which must also be approved by the portfolio manager.

Table 1 shows an overview of some agreements that provide unsecured loans to institutional borrowers. Protocols are sorted according to their Total Value Locked (TVL).

Figure 1: TruFi Lending System from truefi.io

Unsecured Lending Market Overview

Table 1

Table 1 shows an overview of some agreements that provide unsecured loans to institutional borrowers. Protocols are sorted according to their Total Value Locked (TVL).

The total FDV MC of all unsecured lending protocol native tokens in Table 1 is $341 million, which is equivalent to 6.6% of the cryptocurrency lending space, 0.7% of the DeFi space, and 0.03% of the total cryptocurrency MC. In addition, the total TVL is $384 million, which is equivalent to 0.6% of DeFi TVL. These numbers show how small the market share of the unsecured lending protocols in Table 1 is compared to the entire DeFi and cryptocurrency space. On the other hand, they illustrate growth potential given the size of the traditional off-chain unsecured lending market. The growth potential becomes even more apparent when looking at the competitive average loan APY of 8.6%, including native token rewards across all protocols. Note that lending to an unsecured protocol involves higher risk than lending to an over-collateralized lending protocol such as Aave, thus justifying higher lender compensation.

Token Performance Comparison

A comparison of historical valuation developments for relevant tokens in Table 1 can provide insights into potential future trajectories. However, the token valuation measured in FDV MC depends on many factors such as general market conditions, adoption of individual protocols, and the token design itself. Tokens with low value capture attributes may underperform while products (lending platforms) may outperform in terms of TVL and loss ratio. Therefore, comparisons will be made on multiple levels. An overview of token design and value capture properties provides an initial insight into the expected relevance to overall protocol adoption. For example. Tokens that capture strong value from protocol revenue may be more representative of the general performance of the protocol than tokens with limited value capture mechanisms. Significant token metric relationships are then compared against the current time snapshot. The last coin performance analysis focuses on historical development.

Token Value Capture

Table 2

Table 2 summarizes the value capture properties and utilities of the top 6 protocols in Table 1. All tokens provide governance power to holders and stakeholders respectively. Additionally, Maple, Centrifuge, and TrueFi leverage staking in exchange for secondary receipt tokens. Receipt tokens, sometimes designed as a voting escrow (ve) model, are also used as a vehicle for distributing fee shares to loyal supporters. In the case of Centrifuge, Maple, TrueFi, Clearpool, and dAMM, fee sharing is offered directly or through distributed repos. Goldfinch and Clearpool have no secondary tokens, instead using their primary tokens directly as protocol incentives. All native protocol tokens generate value directly from product usage through already mentioned fee shares, governance or by providing user advantages when staking tokens. This means that a correlation between protocol adoption and token valuation can be expected for all tokens.

Token Metric Relationship

Figure 2 shows the relationship between the deposit in agreement (TVL) and different indicators, such as FDV MC, mean. APY of lenders, number of holders and Twitter followers. Ratios are given as a percentage of the highest value in a category.

The deposit/FDV MC ratio indicates that the protocol's capital adoption exceeds its current market valuation. Note that only unsecured loans and secured deposits are considered in these indicators.

Deposit/average. The APY ratio is an indicator of capital adoption exceeding capital incentives.

The Deposit/Holder Ratio provides an average of deposits per native token holder and is a benchmark for actual user quality in terms of capital size.

The deposit/follower ratio indicates capital adoption per unit of marketing effort. Note that Twitter follower count doesn't necessarily correlate to a product's real-world user adoption.

Follower/Holder Ratio is an indicator of marketing effort compared to actual user adoption of the native token.

Data collection had already taken place in February, but due to drastic changes in the market, all data points needed to be updated. In previous data collections, the rankings of different categories varied widely between protocols. Today, we view Centrifuge as the clear leader across all categories, a direct result of its high TVL. It is twice the TVL of the next highest agreement in Goldfinch. The reason for their success compared to other players may be their innovative form of real world asset (RWA) tokenized collateral.

figure 2

Figure 2: Uncollateralized agreement deposits (TVL) associated with FDV MC, average. APY for lending, number of token holders, Twitter followers, and ratio of Twitter followers to token holders. Ratios calculated based on data in Table 1

Standardized Token Market Cap Historical Comparison

Previous comparisons are relative to the most recent value. Figure 3 shows the historical development of FDV MC for different unsecured lending protocol tokens. These values are standardized by Ether FDV MC to achieve a benchmark for the crypto market. The ordinate is given on a logarithmic scale, which mitigates the appearance of high volatility. Considering the starting point of the period from January 1, 2022 to May 19, 2023, all native unsecured tokens are declining in value relative to ETH.

Some reasons for their poor performance may be as follows:

The cryptocurrency market crashes. Since November 2021, the entire cryptocurrency market has been in a downward trend, and unsecured lending agreements have not been spared. As the price of cryptocurrencies falls, the value of the native tokens of these protocols also falls.

Concerns about the sustainability of unsecured lending. Unsecured lending agreements are a relatively new and untested concept, and there are concerns about their long-term sustainability. Some critics argue that these protocols are inherently risky and that it is only a matter of time before they collapse. Some protocols have already experienced partial fallout, such as Centrifuge, Maple, and TrueFi. Other lending protocols and investment platforms even faced a total collapse, such as Celsius, Voyager Digital, and 3 Arrows Capital, which would have heightened fears.

A safer alternative to mortgages. Secured loan agreements are more popular because they offer a less risky alternative to unsecured loans. As more people turn to secured loans, there is less demand for unsecured loans, which puts downward pressure on the value of these protocols’ native tokens.

Figure 3: FDV MC of different unsecured lending protocol tokens normalized by $ETH FDV MC

Summary and Views

Token designs for unsecured lending protocols demonstrate different approaches and value accumulation mechanisms, where all provide governance capabilities through their tokens, but not all provide direct revenue sharing through staking. Nonetheless, all token designs gain some form of value growth from product adoption.

Centrifuge is currently the most successful unsecured lending protocol in terms of FDV valuation and TVL. Although they also have some overdue loans, their strength lies in their innovative approach to RWA tokenization.

**The overall valuation of all native unsecured lending tokens is lower than the crypto market. ** Too much of some or all of the fallout has happened during the 2022 bear market, leading to a decline in trust in the industry.

In terms of total FDV MC, the unsecured lending industry is quite small compared to the entire DeFi industry (0.7%) and the entire cryptocurrency market (0.03%). Considering this, the enormous relevance of unsecured lending in the traditional financial sector, and the tendency of the market to optimize for capital efficiency, decentralized unsecured lending still shows great potential for growth and innovation. It just needs more time to rebuild trust and innovate to make this happen.