According to economists at the Bank of International Settlements, present DeFi loans do not fund real-world activity.
Earlier in 2022, compared to almost zero at the end of 2020, according to BIS statistics. Recent events involving Terra LUNA and Celsius have generated worries of a crisis in cryptocurrency financing. Economists from the Bank of International Settlements (BIS) said that while on-chain collateral in DeFi lending solves asymmetric information, it does not render the sector immune to boom-and-bust cycles, which are exacerbated by liquidation spirals.
Cryptocurrency lending platforms — where borrowers may deposit crypto assets as collateral to get a loan from lenders — are essential to the DeFi (decentralised finance) ecosystem, according to the institution’s weekly bulletin. However, according to BIS economists, the institutional aspects of these platforms mostly “enable speculation in crypto assets” rather than “real-economy lending.”
“Smart contracts award each collateral type a haircut, or margin, which sets the minimum collateral borrowers must pledge in order to get a loan of a certain amount. “Due to the extreme price volatility of crypto assets, there is over-collateralization: the collateral demanded is often considerably more than the loan amount,” said the advisory.
“As DeFi loans are issued in crypto-assets and backed by crypto collateral, they do not fund real economy operations at this time,” the report said.
In the meanwhile, BIS analysts argue that the necessity for collateral impedes the DeFi initiative’s primary objective: “democratising finance.” When it comes to receiving financial services, those with fewer assets are generally excluded.
The research said, “Due to the anonymity of borrowers, over-collateralization is common in DeFi lending.” “Reliance on collateral also restricts access to loans for asset-rich borrowers, undercutting the advantages of financial inclusion.”
BIS estimates that the overall value of DeFi lending methods will reach $50 billion by the beginning of 2022, up from almost nothing at the end of 2020. Now, the trend has reversed, and the total value locked along with asset values has plunged.