The global financial sector has started to see a drastic change with the advent of crypto-backed loans. The ones who have substantial crypto assets can borrow extra capital by depositing crypto assets as collateral without actually having to sell them.
The interests offered on crypto loans are more competitive compared to those provided in the traditional market. This turns out to be a blessing for lenders to earn substantially higher than what banks are offering. Additionally, in crypto and DeFi, the entire process is faster and simpler to complete compared to the traditional loans one seeks for. These crypto loans serve as the backbone of the entire decentralized finance (DeFi) sector.
However, this can be a little challenging for the ones who have recently entered the market as the process of creating a wallet, using a browser extension, connecting the wallet to the platform, and starting to participate in the lending and borrowing markets is a little trickier than just writing the 4 steps in a sentence.
Adding to these, all DeFi platforms offer crypto loans when you overcollateralize compared to your principal amount. This means they offer you loans when you deposit a significantly higher amount compared to the amount you are borrowing. This is completely contrary to how borrowers borrow with traditional banks as banks allow getting loans of significantly more amount than the assets deposited as collaterals. This is observed to be one of the few features that DeFi borrowers disapprove of. Resultantly, this is also stopping the whole DeFi industry from flourishing to its maximum potential.
Many experts believe DeFi loans with no collateral are one of the missing elements from the decentralized finance sector. This system has the potential to make crypto lending available to a large population of people and bring the entire system of the traditional credit industry to the blockchain. What are zero collateral crypto loans? Is it really possible to get crypto loans without any collateral? Let’s find out.
Collateralized Crypto Loans Explained
A type of secured loan in which the crypto holdings of a person are used as collateral in exchange for capital from a lender are called collateralized crypto loans. Just like a loan in a traditional market, the borrower is required to pay it back to the lender in installments (or in full) before the due date. The lenders receive their crypto back as long as the borrowers pay their loan amount in full.
Types of Collateralized Crypto Loans
Usually, the amount a borrower can receive as a crypto loan is a loan-to-value or LTV percentage of the crypto asset used as collateral. The borrower can borrow up to 50% of the value of their crypto from lenders like Compound Finance and up to 90% from other lenders like YouHodler. The LTV percentage varies from platform to platform. The variation in the LTV value also affects the interest rate offered by the platform.
There are platforms that offer undercollateralized loans as well in which case the LTV value is more than 100% and users can borrow more than the amount they have kept as collateral.
Now comes the third and the most attractive type (for the borrowers) - Zero Collateral Crypto Loans. Borrowers can borrow crypto from lenders without depositing a single penny as collateral. Teller Finance is one of the prime examples of various crypto lending and borrowing platforms that offers crypto loans without collateral to its customers.
Why do Crypto Loans Require Collateral?
While Bitcoin and Ethereum are the most popular crypto assets used as collaterals there are sites that even accept 40 different crypto assets as collaterals. However, the actual question is, why do crypto loans require collateral?
The most fundamental part of the process as a borrower is to make sure that he shall be able to pay back the loan and doing so by providing his collateral is one of the easiest ways to do so. The collateral used for borrowing need not necessarily be physical cash. In the traditional world, we keep real estate like land and house as collateral to get cash loans.
For crypto loans, unlike traditional methods that require a credit check, the lending platform does not need to trust the borrowers that they shall pay back the loan on time because often than not crypto loans are over-collateralized.
There are a few reasons why crypto loans are over-collateralized.
We all know how volatile the crypto sector is. This volatility in the crypto industry means that the collateral value might drop significantly as well as quickly at times. Asking for higher collateral often helps lenders to mitigate the risk.
Over-collateralization of loans ensures that the crypto loans are paid back in time by the borrowers. This is why often the collateral value exceeds the loan value. If the loan is not paid back in time, the borrower possesses the risk of losing his collateral to the lending platform.
Zero collateral Crypto Loans - what borrowers need to know!
The borrowers need not create any account and fulfill KYC requirements in a decentralized finance platform. DeFi platforms are simple plug-and-play solutions where users connect their wallets and start depositing their crypto assets (for collateral or for lending). Once done, the DeFi platform then issues the loans holding a certain amount of collateral which currently is more than the value of the crypto borrowed, until the original loan and its interest are paid back.
If the borrower fails to pay back the loan, the platform takes up the ownership of the collateral similar to how a traditional bank assumes ownership of a house or a car bought on loan if the mortgage lapses.
However, there are certain limitations of crypto loans with collateral value. The lender often limits the amount that the borrower can take out in the form of fiat currency on the basis of the percentage of the crypto deposited by the borrower with the exchange. In the case of crypto loans without collaterals, the system becomes more accessible for non-experts and non-users.
DeFi loans with zero collaterals depend on what the finance world calls the five Cs of Credit: Conditions, character, collateral, capacity, and capital. This makes the system of lending and borrowing simpler, faster, and easier.
How do Zero Collateral Crypto Loans Work?
As we have already learned collaterals are used to protect crypto lenders and their interests in the platform. It keeps the ecosystem fair and ensures that under every condition, the lenders will continue to receive the interest and their full principal. Collateral helps in ensuring a three-way trust between the lender, the borrower, and the platform. This trust is the foundation of the success of any DeFi platform.
In uncollateralized crypto lending, platforms establish trust in primarily 3 ways:
Credit Score By Centralized Institutions
Platforms partner with credit scoring and credit history analysis companies to collect the credit scores of borrowers. A prime example of this is Teller. Teller allows its customers from Singapore to submit their credit ratings from the Credit Bureau of Singapore (CBS). Called SG Loans, the service was developed in partnership with Signum Capital to bring the benefits of traditional finance and decentralized finance together. It was a Singapore-based decentralized lending market built on the Teller protocol via Polygon. Borrowers were able to borrow loans between $500 to $6000 in USDC.
There are many DeFi platforms that allow its users to borrow crypto without any collateral if they are premium members of the platform. The platform opens whitelist spots to some wallet addresses based on their activity on the platform, credit history, successful repayment of loans, and various other factors.
A good example of this kind of platform is Teller’s Buy ETH into the Merge market. In this market, Teller allowed its users to get Ether loans without any collateral if the users held their Fortune Teller NFTs or participated in their Twitter competitions. This way, the Teller is rewarding its current active users by all.
Approval Through Consensus of Onchain Reputation
Under this model, the token holders or the lenders often form decentralized governance with the power to vote on the worthiness of new borrowers and loans based on several factors such as risk involved, loan amount, loan conditions, the past activity of the borrower, and on-chain and off-chain credit data. This is to calculate the credit score of the borrower similar to how traditional banks consider credit scores and evaluate interest rates or collateral value for the borrower.
The user can build his or her trustworthiness by paying back the loans without causing any trouble and on time. All of this data is stored in the blockchain which is then accessed by the lenders in case of new loans.
Advantages of Crypto loans without Collaterals
The total amount borrowed across various crypto networks has surpassed $4 billion in a span of two years. However, this is not the potential growth that the market deserves. Whenever someone borrows $1 from the network he or she has to put up $1.50 of another asset that they already own. This process of over-collateralization is holding back the entire DeFi sector. This can be avoided with zero collateral crypto loans.
Favorable for everyone
To ask for a collateralized crypto loan, the borrower must have substantial capital. Such crypto loans are favorable only to crypto traders and holders who have large crypto positions and don’t wish to sell them. However, in a general scenario, a user comes for a loan only when they do not have enough. Crypto loans without collaterals make that possible.
Removing this key element of collateral can be a big breakthrough in the debt market as it will open the market to a remarkably large set of the audience making it a more open financial system. DeFi can transform this sector completely for good, and this can only be achieved with DeFi loans without collaterals.
The power lies with the community
Crypto loans without collateral remove the power from the hands of intermediary parties and transfer it back to the people. The opportunities now lie in the collective judgment of the people across the globe. This brings in a vast untapped layer of underwriting potential from millions of people who are trying to identify new sources of credit.
With uncollateralized loans, DeFi gives people the power to underwrite in a manner that the traditional financial system is unable to do today. You do not have to be a part of a particular jurisdiction to avail of the loan. All you have to do is have a good on-chain credit history and other few similar conditions in place to avail of the loan from any part of the world.
Risks of Borrowing Crypto Without Collateral
There are platforms that are experimenting with undercollateralized or zero collateral crypto loans, which means borrowers can receive a loan valued higher than the deposited collateral or even without any collateral.
Scams and Frauds
Another risk in obtaining DeFi loans with no collateral is that the ones offering such loans might be fraudulent actors who wish to steal the crypto assets or identity of the borrower. In the case of crypto loans without collaterals, one must first look for the red flags before entrusting the lender with their crypto assets.
You must be careful that you are not giving away any confidential information. Research the lender before giving them your asset and check if they have been involved in fraudulent cases before. Also, if the loan agreement sounds too good to be true, do your due diligence first.
There are some crypto lenders who agree to provide crypto loans with zero collateral in return for extremely high interest rates, shorter payback periods, or smaller amounts of lendable funds. This is done to hedge losses if a borrower is unable to pay back his debts. These types of loans are not that beneficial for traders who are often looking to increase their position size. Always go for established protocols like Teller. to ensure such situations do not occur.
The future of uncollateralized lending
The only type of no collateral crypto loans that have garnered maximum attention from crypto users is flash loans as the tenure of the loans only last for a few seconds or minutes. No collateral loans with long tenures are still in its infancy.
According to experts, if the zero collateral crypto loans are paid proper attention to and is perfected in a few years, it has the potential to bring the $11 trillion credit industry to the blockchain systems. Uncollateralized lending has the potential to bring a proper shift in the lending process which until now was focusing on the credit-led collateral-based lending protocols.
Initially, a lot of doubts and concerns paved the path of DeFi loans with no collaterals however, the continued growth of the uncollateralized protocols in 2021 has started to cast away all the doubts. The first partial yet bold step towards uncollateralized lending was the credit delegation product by Aave. This product allowed one user to delegate his collateral with the other which also allowed the borrower to loan out more than his collateral permits.
This was a sort of semi-collateralized system since the borrower could use someone else's collateral to seek the loan. Many new ways have been explored and introduced by many other companies that are offering these services. As we discussed Teller, it is demonstrating a working product that is bringing the best of both worlds of TradFi and DeFi.
The new emerging sector has started to see many unsecured protocols that are mixing off-chain credit data with on-chain governance. While these chains put the power to vote in the hands of the token holders they also impose elements such as risk tolerance and loan conditions.
Unsecured lending is constantly improving itself via its versatility in the lending space and its services. The future of on-chain borrowers is expected to depend upon the qualification for a loan based on the composition of all five Cs namely capacity, character, capital, collateral, and conditions all on the basis of his lending history.
The uncollateralized lending protocols have also established a group of approved stakers interested in the success of the protocol. They are also engaging their community users as well as token holders to determine the risk appetite of the protocol. Moving forward the conditions such as expert delegates, the wisdom of the crowd, the black box credit model, and assessing the creditworthiness of borrowers shall determine the borrowing potential of the user in the unsecured lending protocol sector.
Zero-collateral crypto loans are viable and secured just like any other traditional loans because they are built on secured blockchain technology. The smart contracts ensure that the rules of transactions, governance, reputation checks, and lending and borrowing contracts are complied with by the users at all costs. Billions of dollars have already been deposited in the leading borrowing platforms but they all operate on collateralized lending mechanisms.
Uncollateralized lending is new, fresh, and a game-changer for this sector’s adoption. Companies like Teller have built successful POCs, functional products, and live markets that are offering zero-collateral loan services to its users. Experts believe that with the right impetus and technology, this sector has the potential to revolutionize the entire lending-borrowing mechanism.