Author: Go2Mars, HKUST Crypto-Fintech Lab

Dear readers,

I am honored to introduce to you this "2023 Global Decentralized Financial Lending Track - Insight Analysis Report". As the director of the Hong Kong University of Science and Technology Digital Finance Lab (HKUST Crypto-Fintech Lab), I have been committed to promoting the development of crypto financial technology and exploring innovative possibilities in this field. This report is a carefully crafted result and insight shared by our team and Go2Mars Capital, combining academic research and industry practice.

In the past few years, the rise of Web3 technology has brought about tremendous changes in the financial industry. Web3, with its core features of decentralization, security, transparency, and programmability, has brought unprecedented opportunities and challenges to the lending field. With the use of technologies such as blockchain, smart contracts, and cryptocurrencies, the financial market is undergoing a transition from traditional centralized models to decentralized models.

This report aims to delve into the development trends, key challenges, and prospects of the Web3 lending track. Researchers from Go2Mars Capital and our lab's research team have conducted extensive research and analysis in this field, engaging in in-depth discussions with experts and practitioners in the industry. We will provide a comprehensive overview of key topics such as Web3 lending protocols, decentralized lending markets, asset collateralization, and risk management. Additionally, this report will also introduce some of the latest lending innovation cases, with Prestare Finance being an innovative project from our lab, exploring how Web3 technology promotes the development and innovation of the financial market. We will explore emerging areas such as blockchain-based lending protocols, decentralized lending platforms, and lending derivatives, and discuss their potential impact on the traditional financial system.

Through this report, we hope to provide readers with a comprehensive understanding of the Web3 lending track and valuable references for practitioners in the industry, researchers in the academic community, and policymakers. We believe that with the development of Web3 technology, the lending market will become more open, efficient, and inclusive, contributing to the sustainable development of the global financial system.

Finally, I would like to sincerely thank the hard work and support of our lab team members and partners from Go2Mars Capital, as well as the attention and support of our readers. I hope this white paper can bring you inspiration and guidance.

Wishing that our joint efforts can promote a better development of the financial world and pave the way for the future of financial technology. Let's work together!

Kani CHENHKUST, Department of Mathematics(Director).Fellow of Institute of Mathematical Statistics.Director of HKUST Crypto-Fintech Lab.

Preface

Lending is the beginning of everything in the financial market, it is the source.

Whether it is "The Wealth of Nations" or Mankiw's economics textbooks, we can easily understand that the core of financial activities is based on trust between people, which allows for the mutual borrowing of funds or assets, thus optimizing resource allocation.

Lending is a credit activity, referring to the lender (bank or other financial institution) lending monetary funds to the borrower (enterprise, individual, or other organization) according to certain interest rates and conditions to meet their production or consumption needs. In lending activities, the borrower can increase their income by leveraging their capital, which is the role of leverage. However, leverage also amplifies the borrower's risk, and if the borrower fails to repay on time, it can lead to losses or even bankruptcy. To mitigate or transfer this risk, people have invented various financial derivatives such as futures, options, and swaps, which can be used to hedge or speculate on market fluctuations. It is no exaggeration to say that finance and financial derivatives are built on the underlying proposition of "lending".

Due to the inconvenience of centralized finance, people have turned their attention to blockchain, hoping to achieve more efficient, fair, and secure financial services through decentralization. Decentralized lending is one of the important application scenarios, using smart contracts to match lenders and borrowers, lock assets, calculate interest, and execute repayments, without relying on any third-party institutions or individuals.

As of now, the on-chain DeFi lending track has become one of the most important tracks in the blockchain market, with a TVL of $14.79 billion. However, there is a lack of innovation in current DeFi lending protocols, and the market focus is gradually shifting. How to innovate on the existing models and integrate the latest technologies has become a problem facing innovators.

The DeFi lending track needs a new narrative.

Part 1: DeFi Lending Principle Deconstruction - How Decentralization is Changing the Development of Financial Lending

The Distributed Revolution at the Foundation of Finance: From Traditional Finance to "Decentralized Finance"

"Lending can promote the flow and accumulation of capital. Capitalists can lend idle capital to those in need of financial support, thereby promoting economic development and capital accumulation."

—Adam Smith, "The Wealth of Nations"

A core function of the financial sector is to channel savings into productive investment opportunities. Traditionally, uninformed savers deposit their money in banks to earn interest; banks then lend funds to borrowers, including businesses and households. Crucially, as lenders, banks screen borrowers to assess their creditworthiness, ensuring that scarce capital is allocated to the best use.

In the screening process, banks combine hard and soft information, with the former including the borrower's credit score, income, or educational background, and the latter typically obtained through extensive relationships with the borrower. From this perspective, the history of financial intermediaries is an exploration of improving information processing. For borrowers who are difficult to screen, lenders may require collateral to secure the loan, thereby mitigating information asymmetry and aligning incentives. For example, entrepreneurs often have to pledge the equity in their homes when applying for a loan. If they default, the lender can seize the collateral and sell it to recover losses.

Collateral has played a widespread role in lending for centuries, with secured loans using real estate as collateral dating back to ancient Rome. Over time, market vehicles and forms have changed, and DeFi lending platforms also bring together depositors and potential borrowers without a central intermediary like a bank. Specifically, lending activities take place on the platform—or a series of smart contracts that manage loans according to predefined rules. On one side are individual depositors (also known as lenders), who deposit their crypto assets into so-called liquidity pools to earn deposit interest. On the other side are borrowers, who obtain crypto assets and pay borrowing interest. These interest rates vary based on the crypto assets and demand for loans, while also being influenced by the size of the liquidity pool (representing the supply of funds). The platform typically charges a service fee to borrowers. Due to the process being automated, loan issuance is almost instantaneous, and the associated costs are low.

A key difference between DeFi lending and traditional lending is the limited ability of DeFi lending to screen borrowers. The identities of borrowers and lenders are hidden by encrypted digital signatures. Lenders therefore cannot access information such as the borrower's credit score or income statements. As a result, DeFi platforms rely on collateral to align the incentives of borrowers and lenders. Only assets recorded on the blockchain can be borrowed or used as collateral, making the system largely self-referential.

Typical DeFi loans are issued in stablecoins, while collateral consists of higher-risk unsecured crypto assets. Smart contracts assign a haircut or margin to each type of collateral, determining how much minimum collateral the borrower must provide to obtain a given loan amount. Due to the high price volatility of crypto assets, this leads to over-collateralization—required collateral often far exceeds the loan size, with the minimum collateralization ratio on major lending platforms typically ranging from 120% to 150%, depending on expected price appreciation and volatility.

"The truly amazing thing about the long tail is its scale. Combine enough non-hit products on the long tail, and you have a market bigger than the hits."

—Chris Anderson

The long tail effect, initially described by Chris Anderson, the former editor-in-chief of "Wired" magazine, in 2004, is used to describe the business and economic models of websites such as Amazon, Netflix, and Rhapsody. It refers to the phenomenon where the total revenue accumulated from previously overlooked, low-selling, but diverse products or services exceeds that of mainstream products due to their large total volume. This effect is particularly significant in the internet field. Long-tail assets refer to assets with low liquidity, trading volume, and market value. These assets are often not well-recognized, resulting in relatively low trading volume and market value. In the crypto asset field, most assets belong to the long tail. These assets carry relatively high risk due to their low liquidity and potential price volatility.

Current mainstream lending protocols such as Aave isolate collateral assets and apply different collateralization ratios and interest rates to different assets based on their risk. This approach effectively protects investors' interests and prevents significant losses due to price fluctuations of a single asset. However, Aave on the Ethereum mainnet currently only supports blue-chip tokens such as DAI, USDT, USDC, ETH, and CRV, which account for only a fraction of the total market value of tokens on Ethereum. This limitation greatly restricts the development of the lending market.

Due to the support for only a few blue-chip tokens, many investors are unable to use lending protocols for borrowing operations. This means they cannot utilize their holdings of other assets to obtain liquidity or invest through borrowing. This represents a significant loss for investors. Additionally, the lending market becomes relatively limited, as investors can only choose from a limited number of assets, unable to fully leverage the market's potential. This also hinders the development of the lending market.

To address this issue, lending protocols supporting long-tail assets have emerged, providing investors with more choices by supporting a wider range of asset types. Investors can use their long-tail assets for lending operations and obtain liquidity. These protocols can unlock untapped liquidity in the market. Many long-tail assets are underutilized due to a lack of liquidity, and these protocols provide liquidity for these assets, enabling them to play a role in the market.

Reference to Euler Lending Protocol

Euler Finance is a permissionless DeFi lending protocol. Anyone can list almost any token for lending on Euler, as long as the token is listed on Uniswap v3 with a WETH trading pair. Listing tokens without permission carries high risk, but Euler has proposed a series of risk management concepts and solutions—

• Asset grading mechanism: Euler Finance uses a risk-stratified asset grading system, categorizing assets into isolation, crossover, and collateral layers to protect the protocol and users from risk overflow. Isolation layer assets are the highest-risk assets, only usable for regular lending, and users cannot use these assets as collateral to borrow other assets, nor can they borrow multiple isolation layer assets in the same account; crossover layer assets are medium-risk assets, usable for regular lending and crossover lending, and users cannot use these assets as collateral to borrow other assets, but they can borrow multiple crossover or isolation layer assets in the same account; collateral layer assets are the lowest-risk assets, usable for any type of lending, collateralization, and crossover lending, and users can use these assets as collateral to borrow any other type of assets, and can borrow multiple collateral layer, crossover layer, or isolation layer assets in the same account.
• Decentralized price oracle: In traditional lending protocols, the protocol needs to use a price oracle to assess a user's debt repayment ability. A price oracle is a service that provides asset price information, helping the protocol determine the collateral value and borrowing capacity of users. However, traditional price oracles are often centralized, relying on a few trusted data providers to supply price information. The problem with this approach is that if data providers are attacked or fail, the protocol and users may suffer losses. Euler Finance uses Uniswap v3's TWAP as a price oracle, meaning it calculates the average price of assets based on historical trading data on Uniswap v3. TWAP is a commonly used financial metric that determines the average price of assets by calculating the weighted average price over a period of time. Euler Finance uses TWAP as a price oracle to more accurately assess a user's debt repayment ability and avoid the risks associated with traditional price oracles.
• Dynamic liquidation ratio: In traditional lending protocols, when a user fails to repay a loan on time, the protocol initiates a liquidation process, selling the user's collateral to repay the loan. Liquidation is often a painful process, as it can result in users losing their collateral and potentially have adverse effects on the protocol and other users. Additionally, the liquidation process also faces the issue of miner-extractable value (MEV). MEV refers to the additional revenue miners can obtain by reordering transactions. During the liquidation process, miners can prioritize high-value liquidation transactions by reordering transactions to gain additional revenue. To address these issues, Euler Finance introduces a dynamic liquidation mechanism, using dynamic liquidation discounts and liquidation ratios to achieve soft liquidation and reduce MEV. Dynamic liquidation discounts refer to the protocol dynamically adjusting liquidation discounts based on market conditions and risk parameters to ensure users receive a fair price during the liquidation process. Dynamic liquidation ratios refer to the protocol dynamically adjusting liquidation ratios based on a user's debt repayment ability and risk parameters to prevent users from suffering excessive losses during the liquidation process. Additionally, Euler Finance uses the dynamic liquidation mechanism to reduce MEV. Because dynamic liquidation discounts and liquidation ratios are adjusted based on market conditions and risk parameters, miners cannot gain additional revenue by reordering transactions.
• Adaptive interest rates: In traditional lending protocols, interest rate models are typically static, using fixed parameters to adjust the cost of borrowing based on market supply and demand. The problem with static interest rate models is that they require predetermined parameters to ensure the protocol's capital efficiency. Capital efficiency refers to the protocol's ability to fully utilize funds provided by depositors while ensuring borrowers receive reasonable interest rates. If parameters are set unreasonably, the protocol may experience idle funds or excessive borrowing, leading to losses for the protocol and users. To address this issue, Euler Finance uses control theory to automatically adjust reactive interest rate models to maximize the protocol's capital efficiency. Control theory is a mathematical method that helps the protocol dynamically adjust interest rate model parameters based on market conditions and objectives. Euler Finance uses an algorithm called a PID controller to implement reactive interest rate models. A PID controller is a commonly used control algorithm that adjusts the output signal based on the error signal. In Euler Finance, the error signal refers to the difference between the actual utilization rate and the target utilization rate in the market, and the output signal refers to the borrowing interest rate. Euler Finance uses a PID controller to implement reactive interest rate models, adjusting borrowing interest rates based on the difference between the actual utilization rate and the target utilization rate in the market. If the actual utilization rate in the market is higher than the target utilization rate, the protocol increases the borrowing interest rate to encourage depositors to provide more funds and suppress excessive borrowing by borrowers. If the actual utilization rate in the market is lower than the target utilization rate, the protocol lowers the borrowing interest rate to encourage borrowers to use more funds and suppress excessive deposits by depositors. The purpose is to allow the protocol to automatically adapt to market changes and maintain efficient capital utilization.
• Sub-account protection: In traditional lending protocols, users typically manage their lending positions in a single account. The problem with this approach is that if users want to simultaneously engage in multiple types of lending, they need to manage all their lending positions in the same account. This can make it difficult for users to manage their lending risks and may have adverse effects on the protocol and other users. To address this issue, Euler Finance introduces a sub-account mechanism to help users manage multiple lending positions and provide options for protective collateral. Sub-accounts refer to users being able to create multiple independent accounts within the Euler Finance protocol, each able to independently manage its own lending positions. This allows users to more flexibly manage their lending risks and better utilize the features provided by the protocol.

For example, if a user wants to engage in two different types of lending simultaneously, they can create two sub-accounts in Euler Finance, each dedicated to managing a different type of lending position. This allows users to better control their risks and make better use of the protocol's features. Additionally, Euler Finance provides the option of protective collateral, allowing users to set protective collateral in their sub-accounts to prevent unexpected liquidation.

Looking ahead to the future of the DeFi lending market, we can foresee a competitive landscape dominated by "two superpowers and many strong players." These two superpowers are Aave and Compound, the largest and most mature DeFi lending platforms in the market.

In the future, the development of DeFi lending protocols may evolve in two different directions. One possible direction is to design economic models around the relationship between protocol revenue, liquidity provider (LP) incentives, and total value locked (TVL). This approach primarily aims to optimize the protocol's economic model to increase its revenue-generating capacity while providing more incentives to liquidity providers, thereby attracting more funds into the protocol. This may be achieved through adjusting interest rate models, optimizing collateral liquidation mechanisms, and introducing new incentive measures.

Another possible direction is to integrate new technologies, such as decentralized identity (DID), to further strengthen the on-chain credit system and introduce traditional financial lending models to the blockchain. This approach may involve introducing on-chain credit assessment mechanisms, allowing borrowers to obtain more favorable lending terms based on their credit scores. This way, DeFi lending protocols can better align with the traditional financial system, providing users with more diverse lending options. Additionally, this approach may be achieved through supporting more types of collateral, introducing new risk assessment models, and optimizing credit scoring algorithms.

Looking ahead to the future of the DeFi lending market, we can foresee a competitive landscape dominated by "two superpowers and many strong players." These two superpowers are Aave and Compound, the largest and most mature DeFi lending platforms in the market. As supergiants in the DeFi lending space, Aave and Compound will serve as the infrastructure for the entire ecosystem. They will provide the foundation for other lending protocols to establish and grow. Their scale, scope, and reputation will make them an integral part of the DeFi lending market.

At the same time, other lending protocols will focus on specific niche areas of the market to create their competitive advantages. For example, some protocols may specialize in real-world assets, also known as real-world assets (RWA). These protocols will bridge the gap between traditional finance and DeFi, allowing users to use real-world assets as loan collateral. Another specialized area may be liquidity staking derivatives (LSD). These protocols will allow users to earn returns on various Ethereum staking derivatives. By focusing on these niche markets, these protocols can attract users who want to maximize the returns on their cryptocurrency holdings.

In summary, the future of the DeFi lending market is likely to be characterized by a "two superpowers and many strong players" competitive landscape. Aave and Compound will serve as the infrastructure for the entire ecosystem, while other lending protocols will focus on specific niche areas of the market, differentiating themselves and creating their competitive advantages. This dynamic landscape will provide users with a wide range of choices for lending in the DeFi space.

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References

[1] Aave Document Hub

[2] Yield Protocol Documentation

[3] Compound Documentation

[4] Pandle Documentation

[5] The Maker Protocol White Paper | Feb 2020

[6] Introducing BendDAO – Portal

[7] ParaSpace as First Cross-Margin NFT Lending Protocol – ParaSpace

[8] NFT Lending Race Report: Financial Innovation from Idle Assets to Liquidity | Gryphsis Academy

[9] Blend: Perpetual Lending With NFT Collateral – Paradigm

[10] NFTFi Development History: An Abstract Narrative of Paradigm Evolution | Zonff Partners

[11] White Paper – Euler Finance

[12] White Paper – dAMM Finance

[13] White Paper – OpenLeverage

[14] Centrifuge Documentation

[15] Discussing the RWA Track from the Perspective of Underlying Assets, Business Structure, and Development Path | Mint Ventures

[16] OB30 Talk -RWA Ecosystem Analysis 2023 | Openblock

[17] Curve stablecoin design | Michael Egorov, Curve Finance

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