The biggest problem in DeFi lending right now is adverse selection imo.
I'll illustrate it with the classic lemon car example used in my GT class, and share some thoughts about potential solutions. A thread:
1/n
Imagine you're buying a used car but there exist two types of cars at the dealer: peach (good) and lemon (bad, e.g. had an accident).
Both are polished on the outside so you as the buyer can't tell the difference, but the dealer knows.
2/n
Suppose a peach is worth 20k and a lemon is worth 10k.
Since there is asymmetric info between you and the dealer, you would price every car at its expected value, which is a price between 20k and 10k and depending on what you think the percentage of each type there is.
3/n
e.g. if you think it's a 50-50 chance then you'd be willing to pay 15k for a car of unknown quality. If the other buyers think in the same way, then 15k becomes the market buying price for used cars.
4/n
The problem: at a market price of 15k, the dealer loses money if they sell a peach. Therefore they'll sell more lemons to make profits.
Over time, there will be less and less peaches and lemons overflow the market. This is adverse selection induced by asymmetric info.
5/n
Switching back to DeFi lending: there are peach (low default risk) and lemon (high default risk) borrowers in the space.
Since lenders typically dont know the credit history of borrowers, they will treat everyone as if they have an equal default risk between high and low.
6/n
Lenders will set interest rates, collat ratio, optimize portfolio, etc. according to this framework that everyone has a medium risk.
Then adverse selection happens: over time, good creditors will think the current borrowing cost is too high and quit the protocol.
7/n
Good creditors can switch to another borrowing source where they can prove themselves as a good creditor by KYC to get lower rates.
Bad creditors will remain in the Lemon Protocol (cool name), and the quality of funds deteriorate over time.
8/n
Solution:
On the conceptual level, the most effective solution to asymmetric info is signaling, which is a fancy economics term for 'revealing info'.
9/n
In the used car market most dealers offer Carfax reports. In Tradfi lending, individuals/companies has a credit score from an indep credit rating agency like FICO or Moody's.
As you can see here, signaling is often done thru third party verification processes.
10/n
You might think that the concept of signaling or revealing borrower info sounds somewhat contrary to the promises of DeFi lending, which I agree.
But as the DeFi ecosystem matures, on-chain data can serve as a good info source too.
11/n
Earlier today I read about an interesting project @arcxmoney. They attempts to establish an on-chain credit score system that determines each user's LTV or collateralization ratio from their on-chain credit history. It's for their users only, but interesting approach.
12/n
Another direction is to use a KYC-like process for credit but with ZKproofs: like showing your income is above a certain range without revealing your bank account.
This is an ambitious approach, but once solved, it can open doors to undercollaterllization for the masses.
13/n
Of course there's still the long-lasting problem that there is little consequence to just run away from the loan and open a new wallet. The solutions I discussed above can prevent adverse selection, but we still need a good solution on the runaway type of default.
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@MingXDynasty
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