Introduction
Within the fast-rising “Real Yield” movement, undercollateralized lending has emerged as one of the most discussed and desirable income streams in the decentralized finance (DeFi) sector.
Many publications have already covered this topic, but at Treehouse Research, we want to add our own perspective and highlight some important angles.
In this article, we will begin by examining the concept of credit itself, why it matters to economies and businesses, and how it shapes financial systems.
After that, we will explore existing DeFi credit protocols, analyzing both their advantages and weaknesses when compared to traditional finance (TradFi) and centralized finance (CeFi).
Finally, we will share our thoughts on the critical developments that could define the next phase of growth in DeFi credit markets.
Credit: The Modern Way of Borrowing and Lending
Borrowing and lending have been part of human life since ancient civilizations, dating back to Mesopotamia. Early lending was similar to today’s pawnshops, where people would leave an item of value as collateral to secure a loan.
Over time, the idea of credit developed further: owners of resources would lend production tools or goods to workers in return for repayment. Failure to repay could result in severe consequences, including enslavement in ancient societies.
In the modern world, credit is the backbone of business and economic growth. It allows companies and even governments to access capital without giving away ownership. By using credit, firms can increase investment, expand operations, and fuel higher consumption, which accelerates economic activity.
In traditional finance, credit is divided into two major types: secured and unsecured credit. A mortgage is secured credit because the property serves as collateral. A credit card, on the other hand, is unsecured credit, backed only by the borrower’s trustworthiness and repayment ability. Both forms of credit create new money in the system.
For example, when someone buys a home with a 20% down payment and finances the rest through a mortgage, the bank essentially creates credit by lending the balance. On a larger scale, when the U.S. Federal Reserve buys Treasury bonds, it is effectively lending to the government—this, too, is credit creation.
In contrast, most lending in DeFi today follows the pawnshop-style model, where borrowers put down assets worth more than the loan itself.
This prevents true credit creation. To illustrate, imagine Elon Musk needing to deposit US$1 billion in Tesla stock to borrow US$500 million for a house. This would be highly inefficient, especially since he could easily get much larger loans from banks without locking up so much of his own wealth.
Credit as a Financing Tool for Businesses
Businesses typically raise money in two ways: equity financing or debt financing.
- Equity financing involves selling ownership stakes to investors. While it provides funds, it dilutes the founder’s ownership and future upside potential.
- Debt financing, however, allows businesses to borrow money while keeping control of their operations. Debt creates credit because lenders provide capital in exchange for repayment with interest, rather than ownership stakes.
For many businesses, debt financing is preferable because it protects ownership while still providing the capital needed to grow.
Lenders, in turn, are more comfortable with this arrangement since they have legal claims over a borrower’s assets in the event of default, unlike equity holders.
However, obtaining such loans typically requires businesses to meet strict conditions imposed by banks or financial institutions.
Why DeFi Struggles with Credit Creation
Although DeFi has grown rapidly, most lending platforms still rely on overcollateralized loans. Borrowers deposit more assets than they borrow, similar to pawnshop loans. This model works well for traders and investors but limits broader economic use.
The main reason for this is DeFi’s permissionless nature. Unlike TradFi lenders, DeFi platforms do not run background checks, credit scoring, or Know-Your-Customer (KYC) verification.
While this ensures fairness and inclusivity, it also means lenders cannot evaluate the true creditworthiness of borrowers. To reduce risks, platforms require borrowers to lock up more assets than they borrow.
As a result, DeFi lending excludes many who lack significant assets, and even asset-rich individuals often find traditional or centralized alternatives more efficient.
For example, someone with US$10 million in crypto could borrow double that from a CeFi lender after passing credit checks, but in DeFi, they would have to deposit even more just to borrow less. This structural limitation has kept DeFi lending from unlocking its full potential.
The Rise of DeFi Credit Protocols
Despite these limitations, undercollateralized lending protocols in DeFi are slowly emerging. As of December 2022, DeFi lending protocols had a total value locked (TVL) of about US$13.96 billion, with monthly borrowing ranging between US$9.37 billion and US$32.46 billion.
Although small compared to the global TradFi credit market (worth around US$91 trillion), this is still significant progress.
In 2022, DeFi credit protocols originated about US$4.2 billion in loans, showing growing institutional interest. Meanwhile, the collapse of several major CeFi lenders, such as Celsius, caused a credit crunch in crypto markets.
This opened the door for DeFi protocols to step in and fill the gap. Platforms like Maple Finance and Clearpool saw rising demand as institutional borrowers looked for alternatives.
For instance:
- Maple Finance reported that 23% of its lenders increased their lending positions in 2022 despite the market downturn.
- Clearpool hit a liquidity peak of US$145 million in September 2022, a sharp rise even as broader DeFi TVL dropped.
This highlights that while CeFi lenders pulled back, DeFi credit protocols gained traction by providing access to much-needed capital.
How DeFi Credit Protocols Work
Unlike banks, most DeFi credit protocols don’t directly originate loans themselves. Instead, they act as infrastructure providers, connecting borrowers and lenders. Their revenue comes primarily from a share of interest payments or loan origination fees.
- Clearpool charges a 5% fee on all interest paid by borrowers.
- Maple Finance collects a 1% establishment fee for each loan, with most of it going back to its DAO.
In 2022, credit protocols collectively generated about US$10.9 million in revenue, proving that institutional demand for decentralized credit remains strong despite the challenges.
The largest players—Maple Finance, TrueFi, and Goldfinch—have managed to sustain stable revenue, even during times of reduced liquidity across crypto markets.
Borrowers primarily fall into two categories:
- Crypto-native institutions, such as trading firms and hedge funds that face barriers in obtaining loans from traditional banks.
- Businesses in emerging markets, which often struggle with access to affordable financing. Protocols like Goldfinch specifically serve this group, providing loans to vetted fintech companies and credit funds in developing regions.
Notably, platforms like Goldfinch and Credix have kept their default rates at 0%, thanks to careful borrower selection and risk management.
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