TVL is less than 1% of DeFi, is there any hope for unsecured loans?

The DeFi unsecured loan market has huge potential, and it needs enough time to rebuild trust and innovate.

Written by: Achim Struve

Compilation: Luffy, Foresight News

The U.S. unsecured personal loan market hit $21 billion in Q1 2023, compared to just $6.1 billion in total value locked in decentralized finance (DeFi). This means that DeFi also has huge growth potential, especially in the field of decentralized lending. This huge growth potential is exactly the motivation for our research on the current leading decentralized unsecured lending protocols. By comparing the capital adoption, token valuation, incentive impact, and marketing of these protocols, we attempt to paint a clear picture of their market positioning.

The first part of this series provides an overview of the current market situation for underlying native ERC-20 protocol tokens, followed by the second part of this series to provide more detailed on-chain insights into stakeholder token flows.

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Lending is the cornerstone of any financial system. While the lender is getting a return on idle cash, the borrower has quick access to working capital. The lending market in the DeFi field is dominated by overcollateralization, which means that borrowers must deposit more collateral than the loan value. For example, a borrower who wants to borrow USD 5,000 needs to provide USD 10,000 in ETH as collateral. While overcollateralized loans are the norm in DeFi, unsecured loans in traditional finance are just as common.

Overcollateralization ensures that if a borrower defaults, lenders can avoid losses by selling their collateral. Although overcollateralized lending is safer for lenders, it is not capital efficient, thus limiting the expansion of the lending market. We need unsecured lending protocols to break through this limitation of DeFi. Unsecured loans can access trusted credit data to estimate the risk profile of borrowers without disclosing sensitive information on the blockchain. Oracles combined with zero-knowledge proofs are already being developed, which could reduce the need for borrowers to disclose their identities to unsecured lending platforms.

Unsecured loans are an important direction in DeFi. Compared with over-collateralized loan agreements such as Aave and Compound, the annualized yield (APY) of their loans is usually higher, but this also means higher risks.

• Under-secured or unsecured loans increase the chance of default.
• Loan liquidation and repayment of off-chain assets and contracts can take a long time.
• Regarding the security of the lending pool, lenders must rely on the due diligence of the pool managers.
• Lenders may not be able to obtain liquidity when needed because the amount of liquidity a lender can draw from a loan pool depends on the amount of liquidity present in the pool.

Figure 1 is the working principle of the TrueFi loan system. Here, lenders create a pool of loans against which borrowers will receive loans. TRU stakeholders are able to vote on the loan, which must also be approved by the Portfolio Manager

Unsecured Lending Market Overview

Table 1 is an overview of some agreements that provide unsecured loans to institutional borrowers, sorted by the agreement's total value locked (TVL)

The total fully circulated market capitalization (FDV MC) of all unsecured lending protocol native tokens in Table 1 is $341 million, equivalent to 6.6% of the total market capitalization of cryptocurrency lending protocols, 0.7% of the total market capitalization of DeFi, and 0.03% of the total market capitalization of cryptocurrencies. In addition, the total TVL of the above-mentioned unsecured lending agreement is 384 million US dollars, which is equivalent to 0.6% of the TVL of DeFi. These figures show that the market share of the unsecured lending protocols in Table 1 is insignificant compared to the entire DeFi and cryptocurrency space. On the other hand, considering the size of the traditional off-chain unsecured lending market, its growth potential is huge. Looking at the average loan APY of these agreements reaching 8.6%, it can better illustrate their growth potential.

Token Performance Comparison

Comparing the historical valuations of relevant tokens in Table 1 can provide a reference for potential future developments. However, the valuation of tokens in terms of full-circulation market cap depends on many factors, such as general market conditions, adoption of individual protocols, and the token design itself. Tokens with low value capture attributes may underperform while products may outperform in terms of TVL. Therefore, comparisons need to be made at multiple levels.

Token value capture

Table 2 summarizes the value capture methods of the six protocols in Table 1. All tokens provide holders and stakers the power to participate in governance. Additionally, Maple, Centrifuge, and TrueFi leverage staking in exchange for secondary receipt tokens. Receipt tokens are sometimes designed as a voting escrow (ve) model, a vehicle for distributing fee shares to loyal supporters. In the case of Centrifuge, Maple, TrueFi, Clearpool, and dAMM, fee sharing is achieved through direct issuance or buyback. Goldfinch and Clearpool have no secondary tokens and instead directly use their governance tokens as protocol incentives. All native protocol tokens generate value from product usage through already mentioned fee sharing, governance or staking. This means that a correlation between protocol adoption and token valuation can be expected for all tokens.

Table 2: Value Capture Properties and Utilities of Unsecured Lending Protocol Tokens

The relationship between different indicators of tokens

Figure 2 shows the relationship of protocol deposit (TVL) with different indicators such as FDV MC, average annualized return of lenders, number of holders and number of Twitter followers. A ratio is a percentage of the relative highest value in a category

• The TVL/FDV MC ratio indicates the protocol's capitalization relative to its current market valuation. Note that only unsecured loans and secured deposits are considered in these indicators.
• The TVL/average APY ratio is an indicator of capital adoption relative to capital incentives. *TVL/Holder Ratio represents the average deposit of each token holder and is the benchmark of actual user quality in terms of capital size. *TVL/Twitter followers ratio reflects capital adoption harvested per unit of marketing. Note that Twitter follower count does not necessarily correlate to real user adoption of a product. *Twitter followers/holder ratio reflects the degree of marketing compared to actual user adoption.

The above data collection was carried out in February, but due to the drastic changes in the market, all data need to be updated. In previous data acquisitions, the rankings of different metrics varied widely between protocols. Centrifuge is the clear leader in all categories, a direct result of its high TVL. It's twice the TVL of second-place Goldfinch. The reason for its success compared to other players may be the innovative form of real-world asset (RWA) tokenized collateral.

Token Market Cap Historical Comparison

The previous comparisons used the most recent data. Figure 3 shows the historical development of FDV MC for different unsecured lending protocol tokens. These values are in ETH as a benchmark against which to measure the crypto market. The ordinate is given on a logarithmic scale, which mitigates the effects of high volatility. Considering the period from January 1, 2022 to May 19, 2023, all native uncollateralized tokens will decrease in value relative to ETH.

Some reasons why they perform poorly may be as follows:

• The collapse of the cryptocurrency market as a whole. Since November 2021, the entire cryptocurrency market has been in a downward trend, and unsecured lending agreements have not been spared. As the price of cryptocurrencies falls, the value of the native tokens of these protocols also falls.
• Concerns about the sustainability of unsecured lending. Unsecured lending agreements are a relatively new and untested concept, and there are concerns about their long-term sustainability. Some critics argue that these protocols are inherently risky and that it is only a matter of time before they collapse. Some protocols have experienced some level of debacle, such as Centrifuge, Maple, and TrueFi. Other lending protocols and investment platforms are even facing total collapse, such as Celsius, Voyager Digital, and Three Arrows Capital, which in turn will fuel fears.
• A safer mortgage alternative. Secured loan agreements are more popular because they offer a less risky alternative to unsecured loans. As more people turn to secured loans, there is less demand for unsecured loans, which puts downward pressure on the value of these protocols’ native tokens.

Figure 3: FDV MC of different unsecured lending protocol tokens as measured by ETH

Summarize

Token designs for unsecured lending protocols demonstrate different approaches and value capture mechanisms, where all provide governance capabilities for their tokens, but not all provide direct revenue sharing through staking. Nonetheless, all token designs gain some form of value growth from product adoption.

Centrifuge is currently the most successful unsecured lending protocol in terms of FDV valuation and TVL. Although they also have some overdue loans, their strength lies in their innovative use of RWA tokenization.

All native uncollateralized lending tokens underperformed the overall crypto market. There have been too many partial or even total collapses during the 2022 bear market, leading to a serious decline in trust in the industry.

In terms of total FDV MC, only 0.7% of the entire DeFi industry and 0.03% of the entire cryptocurrency market, the unsecured lending industry is still quite small. Considering the great relevance of unsecured lending in the traditional financial field, and the trend of optimizing capital efficiency in the market, decentralized unsecured lending still shows great potential for growth and innovation. It just needs more time to rebuild trust and innovate to make this happen.

*Acknowledgments: I would like to thank Dimitrios Chatzianagnostou for his guidance, decision support and valuable feedback throughout the process of creating the content of this report. Also, thanks to Robert Mullins and Karim Halabi for taking the time to review drafts and provide feedback. *