Lending on the Blockchain: Problems and Solutions

Innovations in blockchain technology are enabling lending on the blockchain. This can enable holders of cryptocurrency to use their holdings as collateral for loans. Participants can even borrow in cryptocurrency itself while using other assets recognized by the blockchain as collateral. But blockchain technology and cryptocurrency are still in their infancy, and blockchain lending still has problems that will only be solved by experimentation.

Lending has traditionally been enabled by large financial institutions including banks. By virtue of their size and established reputation, such banks are able to pool risks and make loans, funded in part by deposits lent to them by consumers, to borrowers, who are expected to generate a profit. Other financial institutions make loans by purchasing financial assets on the open market, often repackaging them and reselling them as securities. Information asymmetries between borrower and lender, risks inherent in market activity, and the costs of enforcing contracts make these large institutions well-suited for facilitating lending.

Just as the blockchain has reduced the amount of trust necessary to administer a currency system, it also has the potential to reduce the amount of trust necessary to facilitate direct lending between individuals, allowing them to bypass financial institutions entirely. But a number of hurdles must be overcome before lending on the blockchain becomes a feasible alternative to large financial institutions.

Trust and Reputation

The blockchain enables relative anonymity (or pseudonymity) in exchange. A buyer need only know a seller’s wallet address to make a purchase using cryptocurrency. But how can lenders ensure they will be repaid? It is important to keep in mind two distinct problems, each of which requires a different kind of solution. First, there is the problem of accounting for payments under decentralized anonymity. This is the technical problem blockchains came into existence to solve.

This is separate from the problem of time-separated exchange under anonymity, for example in cases in which the seller has to deliver the product. After all, payment is only one half of any exchange. If payment happens before delivery, how can a buyer who does not know the seller’s identity ensure they will receive the purchased product? Or, if payment happens after delivery, how can a seller who does not know the buyer’s identity ensure they will receive payment for the delivered product?

Though developments in software can make it easier or harder to solve the second problem, an institutional solution is ultimately necessary. And our original question — “How can lenders ensure they will be repaid?” — is analogous to the second question, not the first, which suggests we will need to look for the answer in market institutions rather than in advances in blockchain tech.

In fact, the problem of time-separated anonymous exchange is not new to the blockchain at all. One of cryptocurrency’s early use cases, for example, was in the online black market. Exchanges like Silk Road hid the identity of users and allowed individuals to transact in bitcoins. You might expect that relative anonymity would lead to high levels of fraud. In fact, however, delivery on Silk Road was quite reliable.  Understanding how reliability was ensured in such an environment can point toward ways to ensure reliability in a relatively anonymous lending market as well.

The Silk Road, along with other exchanges that continue to operate on the dark web, relied on reputation as an enforcement device. The true identity of a user might not be available, but value is built into the history of the user’s past transactions even if the user is known only by a pseudonym. Expectations of ongoing relationships between buyers and sellers in the future promote good behavior. If a seller provides low-quality products or if a buyer refuses to pay a seller after receiving an item, this activity can be identified by users in forums on and off the dark web and affect other market relationships. In principle, similar mechanisms can serve to reduce the incentive for borrowers to default on loans made on the blockchain.

Some technical innovations are already beginning to appear to support the sorts of institutions for reducing the risk that arises from anonymity as lending on the blockchain is enabled by smart contracts. ETHLend uses smart contracts to facilitate loans. Users can negotiate the particulars of a loan, like interest rates, duration, collateral requirements, and so forth. Failure to repay a loan results in the forfeit of collateral. ETHLend is planning to partner with Bloom, a protocol that provides “identity attestation, risk assessment and credit scoring.” SALT (secure automated lending technology) allows users to borrow cash at interest. While loans remain unpaid, borrowers must pay interest. Assets used as collateral must exist on the blockchain and are locked while the loans remain unpaid.

Price Stability

At the moment, investment in cryptocurrency is speculative as the future of the market is uncertain on many margins. Although cryptocurrency and blockchain have proven themselves useful, changes in public policy and continual discovery of new uses exacerbate price volatility. At the moment, this makes dollar lending that uses cryptocurrency as collateral relatively expensive. It also makes the terms of repayment subject to high levels of uncertainty, even for those who borrow cryptocurrency. A borrower of cryptocurrency who spends the borrowed funds before a drop in the value of the cryptocurrency benefits from cheaper terms of repayment, while a borrower who sees the price of the cryptocurrency rise after having spent the funds will face losses as repayment has become more expensive. High levels of volatility in cryptocurrency prices, meaning neither party is sure which one of them will benefit, make intermediation less attractive for both parties.

If volatility in cryptocurrency persists, lending markets are still likely to develop on the blockchain. Lending on the blockchain can occur in dollars instead of cryptocurrency. Just as the Ripple network facilitates transfer of national currencies, blockchain technology can facilitate the lending of the same currencies. In this case, volatility in the price of cryptocurrencies would not be a problem at all. In fact, the full lending capabilities of the blockchain can be developed absent cryptocurrency. Transfer of currency need only be secured by the blockchain much as dollars might be transferred upon the sale of a bond. The only difference is that the architecture of the blockchain performs the service that financial institutions would otherwise provide.

Conclusion

While we do not suggest that readers rush to make loans or borrow using cryptocurrency, the elements are in place for the development of a stable financial market. The blockchain itself can intermediate funds, as evidenced by theory and practice. Difficulties in trust can be ameliorated even without widespread adoption of blockchain for lending. Price volatility of cryptocurrencies, however, will continue to serve as disincentive as this creates instability in the terms of repayment. We are optimistic that problems will be overcome as institutions for managing reputation and risk mature enough to allow for the development of crypto financial markets intermediated by the blockchain. Even if not, blockchain can still serve to intermediate lending of traditional currencies at low cost.

[Note: Cameron Harwick contributed to this article.]

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James L. Caton

James L. Caton is an Assistant Professor in the Department of Agribusiness and Applied Economics and a Fellow at the Center for the Study of Public Choice and Private Enterprise at North Dakota State University. His research interests include agent-based simulation and monetary theories of macroeconomic fluctuation. He has published articles in scholarly journals, including Advances in Austrian Economics and the Review of Austrian Economics. He is also the co-editor of Macroeconomics, a two-volume set of essays and primary sources in classical and modern macroeconomic thought.

Caton earned his Ph.D. in Economics from George Mason University, his M.A. in Economics from San Jose State University, and his B.A. in History from Humboldt State University.