3 Conditions for Cryptocurrencies to Penetrate the Traditional Financial Market
Over the past year, we have witnessed an exponential expansion of the crypto economy as more capital flows into various cryptocurrencies such as DeFi, NFT, crypto indices, products etc., insurance products and decentralized options markets.
The total locked value (TVL) in the DeFi sector has increased across all chains from $18 billion in early 2021 to $240 billion by January 2022. With plenty of liquidity in the ecosystem, cryptocurrency lending has also grown sharply from $60 million in early 2021 to over $400 million as of January this year.
Despite the exponential growth and innovation in DeFi products, the crypto lending market is still limited to tokenized mortgage loans, i.e. pledging one cryptocurrency as collateral to lend another cryptocurrency.
There are a few platforms like Nexo and Genesis that offer NFT mortgage loans, but the service is primarily aimed at institutional investors with top-tier NFTs. Currently, retail investors can only use tokenized mortgage loans.
If the crypto economy is to grow at a scale compatible with any real economy, it must reach a large number of retail users and offer them funding options.
Here are the key conditions that the market needs to develop before crypto banking infrastructure can compete with banks.
Variety of goods and services
One of the most frequently asked questions by people who are new to cryptoeconomics is – what can I buy? With the current infrastructure, there isn’t much to choose from other than NFTs, DeFi products, staking, and liquidity provision.
In the traditional economy, money exists through the exchange of goods for services or vice versa and does not have a 1:1 ratio, so money serves to facilitate the movement of goods and services. In the cryptocurrency economy, money existed before goods and services became widely available to customers. This makes cryptocurrencies difficult to value and unstable.
An economy must have enough goods and services to create enough supply and demand for consumers to use money in exchange for those goods and services. Since there are only NFT and DeFi financial products in the current crypto ecosystem, it is difficult to attract everyone to the economy as there simply isn’t much to consume.
The banking system works by providing sufficient liquidity from customers’ deposits and sufficient customer borrowing needs. With more digital goods and services, especially non-financial goods and services such as art, music, real estate or gaming gear in the metaverse, the banking system will be able to use them as collateral to provide a variety of secured loans. Similar to auto loans or mortgages, consumers in the crypto world will be able to own these products through recurring payments in the future.
Trusted credit rating system
In the current crypto lending market, customers can borrow any cryptocurrency without a credit check or credit scoring system. Because an overcollateralized Loan to Value (LTV) is closely monitored. Once the LTV exceeds the liquidation LTV threshold, the collateral is sold “cheap” to recover the loan. The value of the collateral is never depleted and there is always a reserve in case the value of the collateral suddenly decreases.
In traditional banking, customers have a credit score based on their transaction history and financial status, ie annual income, savings, loan repayments and investments. In the crypto lending market, this is almost impossible as wallets are created anonymously and users can create as many wallets as they want. This makes it difficult to track transaction behavior and generate credit scores.
To change the current structure, users should be encouraged to build a track record of all wallet activities and use some fixed wallets. The marketplace currently has metrics such as the LUNAtic Leaderboard for Terra to gauge order commitments on a given chain, but there doesn’t seem to be a specific credit score for it that assesses the financial status of the order wallet owner.
As more jobs are created in crypto and more people get paid in crypto, wallets are showing a long-term track record, Z encouraged. Incentives can take the form of access to larger loans at lower interest rates; or access to longer-term loans; or even as an airdrop of governance tokens.
A strong credit scoring system benefits both borrowers and lenders. Lenders can earn more fees with less risk by offering more credit to trusted borrowers; Borrowers can access lower interest rates, longer-term loans, and other potential rewards. Most importantly, a credit rating system can help create a more transparent and healthy crypto lending market and attract more consumers to the ecosystem.
Actively managed collateral rating system
Given the highly volatile nature of cryptocurrencies (at least for now), collateral needs to be valued much more frequently than traditional secured loans. Unlike traditional collateral such as cars or houses, whose value is more predictable and does not change significantly in short timeframes, collateral in the crypto world such as NFT or cryptocurrencies can experience sudden downward swings in price in just one day. For this reason, lending platforms need to have robust collateral valuation systems in place to estimate the market value of a property at any time.
Estimating the market value of NFT or cryptocurrency to the minute is not difficult. However, as there are more goods and services in the crypto ecosystem and more assets qualify as collateral, setting up a high-frequency collateral grading system would be very costly.
Alternatively, lending platforms could create something similar to the concept of off-balance sheet risk-weighted assets (RWA) in the banking world, to provide a higher risk weight (lower liquidation LTV threshold) for risky collateral and less for safe-haven assets so that they don’t be sure to have a high-frequency collateral rating system.
For example, blue-chip NFTs such as Bored Ape Yacht Club (BAYC) may be offered a higher liquidation LTV threshold and be rated less frequently. When NFT price history is made available, more data points can be collected and used for more accurate risk weighting.
As more goods and services become available in the economy, a trusted credit rating system and an actively managed collateral rating system will enable the money banking infrastructure. Electronic funds offer more financing options in addition to symbolized mortgage loans.
The future prospects of finance depend on the types of goods and services available to the economy, and only as the crypto economy matures can it approach the size of traditional banks and become a more diverse and attractive market for many develop consumers.
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