Over-Collateralization In DeFi Has Run Its Course

Obtaining a loan through decentralized finance democratizes access to financial services and products. Unfortunately, the industry suffers from a rather steep over-collateralization requirement, making this option unfavorable. I feel like everyone should be able to trade the performance of their tokenized cash flow without posting additional collateral. 

The DeFi Lending Over-collateralization Problem

Even though decentralized finance successfully removes the intermediaries from the equation, the industry still has work to do. While I am confident the current $100 billion in Total Value Locked in Ethereum DeFi is merely a stepping stone, it remains crucial to cater to people outside of the cryptocurrency world. In its current form, decentralized finance is designed mainly for those knowledgeable about cryptocurrency and blockchain. The average person on the street has no idea about these concepts, let alone show any interest in exploring new options. 

To gain that angle to capture mainstream adoption, DeFi lending will need to undergo crucial changes. The use of over-collateralization is straightforward, as these are incredibly volatile assets. Unfortunately, volatility and lending do not go hand-in-hand that well, forcing users to over-collateralize their loans by a large margin. In some cases, it is required to collateralize up to 750% of the amount one wants to borrow. That steep amount limits the funds to be obtained.

It is not hard to see why requirements like these hamper the growth of DeFi. Requiring users to provide so much capital to acquire a loan is not the best approach. I think that financial services need to be democratically accessible by anyone, and that is what DeFi should be about. Unfortunately, it is anything but that in the current landscape. 

One way to circumvent over-collateralization is by using stable assets. Stablecoins have become a staple in the cryptocurrency world over the past few years. However, stablecoins are not the most appealing option in crypto lending, as they lack volatility. For lending providers, there is a very fine line between wild price changes and not enough fluctuations.

Removing The Over-Collateralization Requirements

Although it may seem dangerous to remove over-collateralization from the equation, bear with me for a moment. I believe that users should be able to access loans in a decentralized manner. Moreover, they should choose the cash flow stream they are comfortable with, yet not face any stringent collateral requirements. Capital inefficiencies need to be addressed early on to make that aspect viable for the future. 

Allowing participants to create lending markets, such as through Horizon Finance, is the way to go. As long as users own the underlying tokenized yield stream, they can view the performance of the cash flow without contributing additional collateral. It creates a fair and transparent ecosystem for all users, rather than creating artificial "paywalls" to access this data. 

At its core, Horizon Finance provides a different take on traditional interest rates. The game-theoretic approach for creating decentralized interest rate markets allows participants to set rate expectations. By submitting fixed interest rate bids — shared transparently — users indicate which rates they are happy to receive, although they can never earn more than the bid they submitted.

More importantly, the way Horizon Finance implements this solution strikes me as efficient use of money. On the other hand, over-collateralization is as inefficient as it can be and will hold the DeFi industry back. By removing this barrier from the DeFi ecosystem, more users can explore the decentralized opportunities at their disposal. The current requirements and over-collateralization risks will scare off many potential newcomers.

Closing Thoughts

The future of DeFi still looks bright, even if certain industry aspects are far too inefficient. The initial popularity of over-collateralized lending has given rise to the idea this is how things should be. However, I am confident it is merely a stepping stone toward unlocking the true potential of DeFi lending. A future that doesn't involve steep collateral requirements, let alone over-collateralization.