Overcollateralization remains a pressing problem in the world of decentralized finance. Although there are ways to circumvent the problem, it prevents many people access to lending and borrowing solutions. Below are three ways to make over-collateralization an issue of the past.
Why Overcollateralization Is An Issue
The main problem with over-collateralization is preventing more unbanked or underbanked people from accessing DeFi solutions. More specifically, two billion fall into the unbanked or underbanked category. Those people have limited or no access to financial services and products, making the DeFi sector a welcome alternative. Or that is how it would be, were it not from rather steep collateralization requirements by specific DeFi lending protocols.
Overcollateralization forces users to deposit collateral greater than the amount they want to borrow. It makes sense, on paper, but it is a troublesome scenario for those who already have little or no access to financial services and products. The loan-to-value ratios can be as high as 90% – which is favourable – but can also be as low as 20%. That is the downside of dealing with collateral that is incredibly volatile.
Solving The Overcollateralization Issue
Thankfully, some developers acknowledge this pressing problem. More importantly, they provide different solutions to improve the current situation. Different solutions can have both benefits and drawbacks, yet they mark an essential step in the right direction. It is crucial to bring the unbanked and underbanked people into the DeFi fold sooner rather than later.
The approach by Avarta offers loan and collateral optimization. Users create an “Avarta” of themselves through their wallet addresses. Additionally, they can choose which bits of information become part of this digital identity. That approach can provide sensitive information to trust parties and can speed up safe listing processes.
Furthermore, there is the Avarta Credit Score, which aggregates data from connected wallets across various blockchains. The trust score will help users achieve better collateralization and access to differentiated DeFi products. The team behind this project is proactive and puts their combined expertise to introduce a viable solution to over-collateralization.
Democratizing access to credit is an ambitious goal. However, current technology makes it possible. Sublime is one project tackling the over-collateralization issue by letting users tap into social capital to access credit from lenders. Opting for this approach can reduce the collateral requirements from lenders and introduce an opportunity for users to delegate credit to someone else. Furthermore, all of this is possible in a decentralized and peer-to-peer manner.
Although this concept sounds promising, crowdsourcing credit data to decentralize risk assessment remains an ambitious goal. The benefit to decentralizing this approach is using trust and reputation to gain access to credit from lenders that trust them. However, it remains unclear if lenders will opt for this opportunity. Moreover, lenders remain in charge of collateral rates, even if they can “join forces” in a pool-based structure.
One can find a slightly different approach to over-collateralization in Horizon Finance. On paper, the idea of decentralized interest rate markets sounds exciting. That approach lets protocol participants set rate expectations. Moreover, participants submit fixed interest rate bids, indicating which rates they would like to pay for loans. Even so, it remains up to lenders to accept these offers.
Finding an efficient use of money to solve over-collateralization in decentralized finance remains a priority. The three protocols above all attempt a slightly different approach. Innovation is never far away in cryptocurrency and blockchain, although it is too early to tell which option will be more viable.
The Avarta Credit Score seems to address most potential issues when reducing collateral requirements for decentralized lending. However, the ideas by Sublime and Horizon Finance also have merit and pave the way for a potential solution to this pressing problem holding back the DeFi industry.