In this article we will explore:
(1) Differences in lending between Traditional Finance (TradFi) and DeFi
(2) Ithil’s innovation: the Internal Lending Engine
If you’re already familiar with the basics of loans and collateralisation, you can skip ahead to section two.
(1) Differences in lending between TradFi and DeFi
Lending is a key driving force behind the creation of value, and as a result, wealth. It connects holders of capital to those risk takers with the bravery, wit, chops and ideas to create new value.
At the same time, (new) ventures always carry some inherent risk, and sometimes even the most capable mavericks fail — often due to nothing more than bad timing or luck. As a result, capital is lost.
While many are keen to lend out their surpluses and passively earn returns, nobody wants to lose their capital. That is why different types of loans exist, as well as mechanisms to price the loans and protect lenders against defaults. Let’s take a look.
TradFi loans
In TradFi loans are divided into two main categories. Secured loans and unsecured loans.
Secured loans loans require collateral from the borrower; they must put up assets like a house, car, or stocks. What’s more, the loan-to-value (LTV) ratio rarely exceeds 100% — essentially full collateralisation or more.
As a result, these loans are seen as low-risk for the lender, and cheap for the borrower. They are not very capital-efficient, however, as the borrower cannot borrow more than the total value
Unsecured loans on the other hand, are not collateralised. They are supported by credit score and/or reputation of the borrower only.
This type of loan is possible due to the know your customer (KYC) processes in TradFi. When you must prove your identity before taking an unsecured loan, the idea of grabbing the money and disappearing doesn’t sound great.
Still, the risk of a complete default is much higher, and so the interest rates are much higher as well. For lenders that aren’t risk-averse (the average cryptocurrency enjoyer, basically), unsecured loans can be very interesting.
DeFi loans
In DeFi, practically all loans are collateralised. In general we say:
(A) Collateral amount ≥ borrowed amount = the loan is overcollateralised
(B) Collateral amount ≤ borrowed amount = the loan is undercollateralised
Lending in DeFi is a curiosity in this sense: we’re the only space that uses the collateralisation percentage of a loan as the key differentiator.
This has good reason; DeFi is trustless and anonymous. The closest thing to a tangible identity is a wallet address — linked to an ENS domain at best.
What’s more, a single biological (and soon perhaps virtual) person can have a nearly unlimited amount of wallets, and it’s very hard if not impossible to prove that a wallet address is effectively owned by a biological person. In fact that’s kind of the whole point.
This raises a huge issue from a game-theoretical point of view though. If you’re anonymous, and someone lends you a bunch of money with no collateral to be liquidated in case the loan goes wrong, the optimal move is to simply run off with the money.
In fact, this is also true for undercollateralised loans. That is why the handful DeFi protocols that offer undercollateralised loans, do so through some kind of restriction. Typically, these restrictions are:
- KYC
Mostly useless on-chain, may be needed where real assets are involved (taking a loan to buy a house, a car, lending to a startup, etc). - Credit checks/scores
Slows things down significantly and may be easily circumvented. - Permissioned loans
Discriminatory to the borrowers and not completely decentralised as some central entity decides credit-worthiness. - Restricted movement of funds
Depends a lot on the implementation. Can be implemented as a walled garden, meaning that funds cannot leave the loan issuer’s ecosystem [until the loan has been repaid], which drastically limits usefulness. - Another option is time limited e.g. flash loans which require the loan to be repaid in the same block. Only useful for sophisticated participants, as these requires custom, single purpose atomic actions (usually arbitrage).
The case for undercollateralised loans in DeFi
Undercollateralised lending running on the trustless, permissionless and open rails of decentralised finance is — while challenging — highly desirable. The combined strength of accessible capital and borderless infrastructure is simply too useful to ignore, even for mainstream applications.
Challenges do exist, but the pioneers in the web3 space are working hard to overcome them. In fact, that’s exactly what we’ve done with Ithil.
(2) Ithil’s innovation: the Internal Lending Engine
From the very beginning, Ithil’s team felt very strongly about staying true to the ethos of web3. At the same time, part of the team has a background in traditional finance, and we couldn’t help but notice that some elementary financial instruments are missing from the web3 space. Finally and most importantly, we are practical thinkers, and solution-oriented.
So we asked ourselves, how can we build useful undercollateralised lending infrastructure for web3, without forfeiting some of the core principles we hold so dear?
The solution emerged: an Internal Lending Engine (ILE), coupled with a DAO voting mechanism. Let’s break it down.
What is the Internal Lending Engine (ILE)?
The ILE is built on a simple concept: all lending, borrowing and repaying happens within Ithil’s smart contracts. This makes it possible for anyone to take an undercollateralised loan in true web3 style: completely trustless, permissionless and automatic.
Now you might think: “Ok, very cool, but how can the borrowed money be used if it stays within Ithil’s smart contracts?” That’s a completely reasonable thought, and also how we get to the very cool part.
The ILE consists of two separate groups of smart contracts. These are the Vault and the Strategies.
The Vault
The Vault can be viewed as Ithil’s central bank. It can receive tokens from Liquidity Providers (LPs), and lend out these tokens. When tokens are loaned, a receipt token is created and held within the Vault. This way, the Vault always know who loaned and/or borrowed, and how much.
The Vault also decides the price (interest rate) of loans. This depends on a number of factors:
- The riskiness of a Strategy
- The share of Total Value Locked (TVL) allocated to a specific Strategy
- The specific token to be borrowed and it’s risk factor
- The risk factor of the token used as collateral (bluechip <> shitcoin)
- The utilisation rate of Vault (loans become more expensive the more loans are issued)
The Strategies
The Strategies are smart contracts that can loan from the Vault, and then use the loaned tokens in predefined investment strategies. A Strategy can be viewed as an automated intermediary: it allows Users to take out loans and then deploy those funds to external web3 protocols — without ever directly touching the liquidity held by Ithil’s Vault.
These smart contracts have an added benefit: they remove the difficulties associated with executing complex and/or sophisticated investment strategies.
For example, an Ithil User wishing to run a multi-step DeFi Strategy involving the Balancer+Aura ecosystem does not need to interact with all the different smart contracts in that strategy. They only choose which token pair they wish to LP for, select the boost level (guided by our UI for optimal balance between borrowing costs and yield), and submit the tx.
Another example would on-chain mortgages. An Ithil user would choose an asset to purchase (for example, a Bored Ape or Decentraland LAND) deposit collateral, and choose the loan amount. Ithil would then purchase the asset and give the user a wrapped NFT granting usage rights. Ithil’s Vault would maintain control of the asset until the loan is repaid, giving full ownership to the user.
These are just a few examples of what it is possible with Ithil, an ever-expanding ecosystem of financial products for the next generation of web3 users.
DAO Governance Voting
If you’ve been paying attention, you might ask yourself how this is different from a central(ised) bank that decides single-handedly which Strategies are available. This is where the power of web3 infrastructure really shines. Ithil’s DAO decides through governance voting which assets are available to deposit and which Strategies are deployed.
This puts the power in the hands of the community, as anyone can create a proposal to be voted on by the DAO. If the proposal makes sense for the members, chances are high that it will pass the vote and get implemented.
The liquidity remains safe within Ithil’s smart contracts, but the community can decide where and how far it can reach through voting on the Strategies.
As a result, decentralisation is guaranteed while still enabling safe, undercollateralised loans as a web3 financial primitive.
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