Under-Collateralized Defi Protocols With Covalent
Due to a lack of trying, traditional finance has shown its inability to bank the billions of people around the world that are without access to sufficient financial services. In conjunction with corrupt officials and unchecked government oversight, people’s savings in countries such as Venezuela are becoming more and more worthless by the day. So worthless, in fact, that the image below illustrates how the people of Venezuela are starting to craft baskets and hats out of the country’s banknotes.
How can a financial system sufficiently provide for citizens when the paper the moneys printed on is worth more that the dollar amount ??
Nevertheless, due to Decentralised Finance (Defi), an internet connection is all someone needs to access the digital world of finance and asset ownership. The influence of Defi, however, doesn’t just start and stop in developing countries. Defi promises a fair, transparent and user-centric banking system to everybody around the world. People are free to save, loan, and even lend whenever and wherever they want.
Lending Is The Heart Of Traditional Finance
A common misconception is that the debt/lending sector in traditional finance is nothing compared to the global stock market.
I mean how can it? it’s just debt right? What about apple stock? WRONG!
As seen in the following visualisation, the global bond market ($119 trillion) actually surpasses the global equity markets ($95 trillion) by $24 trillion. This should illustrate the magnitude and importance of lending and loaning in macroeconomics. Even though the global bond market is worth $119 trillion, it is still littered with inefficiencies. For example, there is a prevalent barrier to interoperability between markets and regions as government regulations punish unsupervised cross-boarder financing.
In addition, a significant percentage of liquidity comes from a small number of large entities resulting in a single point of failure that jeopardises efficient and fair market operations. The power of these large liquidity providers was put on display in 2008, as Lehman brothers ‘pushed over the first domino’ that lead to the economic meltdown of the worlds biggest economy.
If only we had an alternative?
Oh wait we do… it’s called Decentralized Finance !!
These 4 key attributes are how Defi can help
- Peer-To-Peer
Protocols such as Aave connect lenders and borrowers in a decentralised manner, which has shown efficiency in delegating risk and distributing reward amongst all users. Defi protocols have no location, no headquarters, no board members and certainly no totalitarian system. This unleashes unlimited exposure to every country on Earth. For example, Americans can now lend money to Africans, and vice versa, in minutes. This is just one example.
2. Real World Bridge
Many Defi protocols allow the collateralization of digital assets such as Bitcoin and Ethereum to borrow a more accepted currency such as the US dollar (USDC). This enables a bridge between the tangible world and the digital one.
3. Smart Contracts
Smart Contracts bring the ability to go into agreements in a trustless, secure and transparent way without knowing or every seeing the person you’re doing business with. The agreement is purely governed by code and at no point has to be accepted by any bias intermediary. This is truly a game changer in the we do business.
4. Credit Worthiness
Most importantly, the concept of collateralization and credit worthiness. Traditional finance runs your historical financial data through complex algorithms to determine your worthiness of receiving credit. Defi does not yet have the technology, nor data available, to create credit scores to assess individuals credit worthiness. This is why Defi protocols only give out over-collateralized loans.
Layer 1 data, however, is not useless. On-chain historical data can be used to determine the credit worthiness of the collateral pledged for the loan, such as Bitcoin. This historical, deep granular data is often interwoven across different chains and scattered amongst multiple blocks on chain. AN ABSOLUTE NIGHTMARE FOR DEFI PROTOCOLS TO ACCESS !
INTRODUCING COVALENT
For a long time this caused a data availability gap in Defi. Until Covalent. Covalent can index, categorise and distribute unstructured and scattered on-chain data to any Defi protocol that requests it. As more people use Defi to facilitate their financial needs, Covalent will be able to capture the data necessary to supply these protocols with similar data sets found in traditional finance.
Covalent Will Bring Under-Collateralized Loans To Defi
As stated above, Defi protocols are yet to efficiently give out under-collateralized loans. Currently, Defi is perfect for funding people to make small purchases such as fixing their broken washing machine or paying their car registration. Defi allows people that may be a week away from getting their paycheck to pay off these sudden and urgent expenses in a quick and hassle free way.
REAL WORLD EXAMPLE (PART 1)
Jane owns $4000 in bitcoin and needs $1500 to fix her broken air conditioner. Her paycheque is in a week’s time but she wants to fix it now. Jane goes to a bank and is instantly hit with a weeks worth of paperwork. She may as well wait for her paycheque. Instead, Jane comes home and sends her bitcoin to a Defi protocol like Aave. She then takes out a loan against it and pays a handyman to fix her air conditioner. In a week’s time when she receives her paycheque, she goes back to Aave, pays off the loan and gets back her Bitcoin. The process of getting the loan took her a couple of hassle free minutes and she avoided the capital gains tax she would activate if she had to sell her Bitcoin to fund the fix. There was no paperwork and no people involved.
However, in order to reach mass adoption people must be able to leverage their assets, and income, to buy things such as Cars and Houses. All the data involved in Jane’s loan is open sourced on the blockchain. Covalent is able to not just access that data, but interpret it into a useful data set that can start to contribute to her financial profile. Covalent will eventually be used to assess peoples credit worthiness.
REAL WORLD EXAMPLE (PART 2)
Jane starts to enjoy the ease and efficiency of Aave and she begins to use it for most of her financial needs. She takes out multiple loans where her LVR (Loan-to-Value ratio) is somewhere from 35%-40% like her first loan in part 1. Aave then implements a new system of evaluating credit worthiness with Covalent’s API. They go to the Covalent API and find Jane’s historical, financial data. It shows that she has always paid her debts on time and increases her USDC holdings in Aave by $1000 a month for the last 12 months. Aave then determines that Jane is worthy of receiving credit with an LVR of 60%. This means that with $4000 worth of Bitcoin, Jane will get $2400 rather than $1500 in part 1.
In the future, Jane will eventually have all her assets and income coming through Defi protocols like Aave. This will allow Aave to algorithmically determine her credit worthiness, with data sets fetched by Covalent’s API. Aave can then start to loan out under-collateralized loans based on her income per month and the value of her digital assets. This is the power that the Covalent API will bring to Defi. Covalent will provide the data that will ‘slingshot’ defi into mass adoption and allow over-collateralized lending.
Defi Should Have Both Under and Over Collateralized Lending
Over-collateralized protocols allow really quick and easy access to liquidity without selling any of your assets (Great way to avoid tax ;) ). So there will always be a market for over-collateralized Defi protocols that service both businesses and individuals. Under-collateralization loans obviously come with a host of risks. However, Defi will be able to provide this service with full transparecy and a complete user-centric direction. In order to evaluate the current mismanagement of an under-collaterized system, the following text compares the leveraged traditional markets and the over-collateralized Defi ecosystem during a market downturn.
Under-collateralized system ( Traditional Markets )
On September 6, 2008, with the financial markets down nearly 20% from the October 2007 peaks, the government announced its takeover of Fannie Mae and Freddie Mac as a result of losses from heavy exposure to the collapsing subprime mortgage market. One week later, on September 14, major investment firm Lehman Brothers succumbed to its own overexposure to the subprime mortgage market and announced the largest bankruptcy filing in U.S. history at that time. In the United States, the stock market plummeted, wiping out nearly $8 trillion in value between late 2007 and 2009. Unemployment climbed, peaking at 10% in October 2009. Americans lost $9.8 trillion in wealth as their home values plummeted and their retirement accounts vaporized.
Over-collateralized system ( Decentralised Finance )
Bitcoin will be used to represent the crypto market in this example as the crypto market usually follows the movements of Bitcoin. Bitcoin is also the most used crypto currency in Decentralized Finance.
On April 14th 2021 Bitcoin hit a record high of $64,650. Over the 40 days that followed, Bitcoin ‘bled’ all the way to a low of $31,000. This was a correction of around 50%. (over 30% more than the initial crash in 2008). Despite such a dramatic downturn, no Defi protocols went offline. The only entities that went offline were the centralised ones such as Coinbase and Coinmarket Cap.
What’s the difference between the two ?
It’s evident that the Over-collateralized, decentralised world of finance operated exponentially more efficient amongst what would traditionally be called a depression in legacy markets. Those that didn’t get liquidated due to leverage trading, still had full access to their funds. They could still send, receive and sell their crypto. There was no bankruptcy filings, no meltdowns, no job losses and no innocent people lost funds or had their access to them locked. Defi operated exactly as it promised it would… unemotionally. This is the power of a world governed by code.
Which financial system would you want your funds in?
The traditional financial system is run by greed, emotion and bias. Defi is run by open-sourced and transparent code. Smart contracts act as the smooth head in a frantic situation. The responsibility doesn’t fall on humans with emotions, rather code with parameters that can’t be altered.
Let me ask again
Which financial system would you want your funds in?
WHAT WOULD HAVE HAPPENED IF LEHMAN BROTHERS WERE A BLOCKCHAIN-BASED PROTOCOL?
I want to try to make this report as data driven as I can but when you are talking about technology, such as Covalent, that is going to shape the future, it’s hard to convey its importance with current data. Therefore, I want to conduct a thought experiment with you. Just imagine Lehman Brothers as a protocol on the blockchain. Not necessarily a decentralised one. Merely a bank that has all of its internal data on the blockchain where it can be viewed by the masses. What would be different?
Firstly, most people aren’t proficient in computer science, so the data Lehman Brothers put on the blockchain could’t be understand by the average customer. However, Covalent’s API could be used to build a system that monitors how leveraged the bank is. Lehman Brothers were reportedly leveraged 30.7 : 1. The warning bells would have been signalled far before a blockchain-based banking protocol had the chance to leverage users money 30.7 : 1. Lehman Brothers would be forced to be more cautious and change the business model from profit-centric to indefinitely user-centric.
COVALENT IS THE KEY
The world is moving to digitise everything. Digitise art. Digitise content. Digitise assets. Digitise ownership. The digital economy is growing at an exponential rate and the fuel that’s going to ignite this growth is data. Data will be the most useful tool in a digital world and Covalent is going to be a core distributor of on-chain data. Covalent’s API, as well as data oracles, will be the data providing catalysts that will allow Defi and digital assets to scale to billions of users around the world. Covalent will help bring prosperity and equality to those that are outcast by traditional finance.