Unsecured borrowing has come to decentralized finance (DeFi).
Aave, a DeFi money market that allows users to earn interest on cryptocurrency and borrow against it, introduced credit delegation in early July. This service allows someone with a lot of collateral deposited on Aave and no desire to borrow against it to delegate their credit line to a third party they trust. In return for essentially co-signing a loan to the trusted third party, the delegator gets a cut of the interest, juicing the return on their deposit.
The development represents a significant shift for DeFi lending, which until now has been predicated on only one of the traditional “four C’s” of credit: collateral. That’s to be expected when lending funds to complete strangers on the internet. Credit delegation is a step toward basing loan decisions on other factors, such as the borrower’s income, savings or track record of repaying debts (“capacity,” “capital” and “character” in the old banker’s formulation).
The step change comes at a time when DeFi is all the rage. On Aug. 15, Aave alone crossed over $1 billion in crypto staked to the overall platform, as measured by DeFiPulse. At present, nearly $7 billion worth of digital assets are staked as collateral fueling this new industry. Only four projects (MakerDAO, Compound, Aave and Curve) have had over $1 billion worth of assets staked at one time.
"We are locking a lot of funds into DeFi," Stani Kulechov, Aave’s CEO, told CoinDesk in a phone call. "We are looking at: How can we utilize that value as much as possible?"
On Aave, Kulechov said, around 75% of users aren't using their credit lines. They are just earning interest on the deposits (and governance tokens).
While it's natural to think in terms of person-to-person lending here, Kulechov said credit delegation is aimed more at institutional-level use cases and sophisticated, price-conscious trading outfits that need options for fast and easy credit. These include over-the-counter desks, market makers, traditional financial institutions looking to borrow stablecoins to trade into fiat for analog-world lending or smart contracts set up to run specifically delineated strategies.
The idea is not that Aave itself becomes the lender but that users with capital earning returns on Aave increase those returns by sharing their credit lines.
To be sure, this is a well-worn road in the traditional world that expands opportunity for many but gets people (sometimes a few, sometimes a lot of them) into trouble.
"I think it's healthy and natural to experiment around these models. But they do have a lot of risks around them, for obvious reasons, if the assets can't be recovered in time for the primary owner," said Joseph Kelly, CEO of Unchained Capital, a company that writes loans against bitcoin collateral.
So how does credit delegation on Aave work? Here goes.
Without collateral, what's backing the loan?
Basically, relevant laws and contracts.
Aave provides access to OpenLaw contracts that allow the entity with the credit line to set up terms for their counterparty to agree to. They can turn to arbitration or the courts in the event of a default.
It's up to the collateral holder to decide which specific requirements to make of those they delegate to. The nice feature that OpenLaw provides, though, is reflecting the contract terms directly in the smart contract that governs the relationship.
"I think the OpenLaw contract was just to show the possibilities. At the end of the day you can decide how to do it," Kulechov said.
How do the deals get arranged?
Right now, the Aave team is doing it and so far it has only done one, for Deversifi, an exchange. "They are market-making," Kulechov said, explaining why an exchange would need to borrow funds.
In other words, this first deal is a long way from a consumer getting an unsecured loan to cover a medical bill or buy a washing machine. It reflects the vision for the services that it will provide liquidity sources to entities that can be verified as worthwhile credit risks.
Aave has not disclosed who delegated the credit to Deversifi.
What we see today in the credit delegation is only a minimum viable product, Kulechov explained. "Now we kind of match the delegators and the borrowers," Kulechov said. In other words it's Aave that promotes the project to people with large deposits and then finds suitable counterparties.
This hands-on process is not scalable, however.
So where is it headed?
This is where tokenomics, or in this case Aavenomics, comes in.
As Aave decentralizes, the vision is that the holders of Aave's governance token, AAVE, would begin handling the scaling of credit delegation. Users would set up pools (vetted and approved by the AAVE holders) where they would seek out entities looking for liquidity options and assess whether they were good credit risks.
Then delegators could look at those pools and decide whether to delegate to them. It would always be up to collateral stakers whether or not they wanted to delegate their credit and whether or not the risk profile of a specific pool was attractive.
"Basically we make it more scalable so we don't need to match these deals," Kulechov said.
Kulechov believes DeFi could become a very attractive source of liquidity for use cases even outside of crypto.
"The idea is that this credit delegation could become a wholesale debt market. Which means if you are a facility in DeFi, CeFi, traditional finance, you could source part of your liquidity from Aave," he said.
Meaning even online lenders that are making loans to regular people in the real world might borrow stablecoins on Aave and convert them to fiat to lend, because Kulechov believes that DeFi will be able to beat interest rates on liquidity sources they usually use, such as private placements and bonds.
This has yet to be tested, but it's the future Aave is eyeing with credit delegation.
How can delegators manage default risk?
Mainly by carefully vetting the borrowers they allow to use their credit lines, or "underwriting," as bankers call it.
But for additional protection, another relevant project is Opium, which announced Saturday it had created a credit default swap (CDS) on the Aave protocol. A CDS is a contract that insures the buyer against a third party defaulting on a loan. The seller collects a premium and in return stands ready to make the buyer whole for potential losses on the loan.
In addition to risk management, CDS can be used for speculation by parties uninvolved in the loan, and these instruments are best known for their role in the 2008 financial crisis. Over the weekend Opium's announcement elicited no shortage of snarky "what could go wrong?" reactions on crypto Twitter (which also made light of the project's name). To be fair, some argue that CDS provide markets with an early warning signal of credit problems.
What about the thing with mortgages?
This is still a work in progress, but the vision is that RealT would tokenize home equity. Then AAVE holders could vote to accept those home equity tokens as collateral on Aave.
If that happens, it would mean both that people with home equity could potentially have a modest way of earning a small return on it and that they could also use it as a home equity line of credit. Obviously this could be quite dangerous, as MakerDAO users learned last year, when users took out personal loans for real-world needs only for the interest rates to spike when the system was tested for the first time.
That said, Aave has mechanisms for lending at stable interest rates. Regardless, new industries just need to take these shots, Kelly said.
"I don't think there's a time when it'll be obvious that the market and technology are mature enough to try these models out," he wrote. "There will be some that implode, either due to credit mismanagement (if centralized) or technology and market issues if decentralized."
Kulechov made a similar point.
"I think innovation should not wait. If you have the ability to get it done, I think you should get it done. But I think always we need to be aware of the risks," he said. "We definitely need to go slowly and securely."
Originally known as EthLend, Aave was funded by a $17 million initial coin offering in November 2017. The team has not released a timeline for the release of version 2.