I love defi and what it stands for. I love the fact that I can lend my capital through a fully decentralized protocol like [AAVE]( or [Compound]( and earn money on it.
I believe however that DeFi will find it hard to grow if all loans can only be collateralised. Think about traditional finance:
1. You take a loan
2. If you don’t pay it back, you get sued and go to jail
3. Alternatively a debt collector may take some of your items to pay back the loan
Step 2 & 3 is where **CeFi x Legal** happens.
As far as I’m aware, as of today (April 2023) there is no such thing in DeFi. I don’t even think one could borrow without collateral in defi. My honest thought on this is that for the future of DeFi to ever grow as large as CeFi, this could only happen if we tackle the above.
**Solutions? Perhaps not.**
If you build a decentralized credit score system to simulate the criteria based on which banks lend money, you are exposing protocols to a linear bank run. You *cannot* trust people.
>I am a good person and grow my credit score, top credit score. The protocol makes money from me for 5 years as I pay back all loans.
I now borrow $10m from DeFi protocol and disappear.
The credit score system wouldn’t work also because one could claim their address got hacked.
6 thoughts on “Can DeFi replace banks without a legal framework?”
DeFi lending as it stands doesn’t replace banks it mainly serves as an alternative source of leverage.
In order to provide unsecured loans similar to banks decentralized lenders would have to be able to sue borrowers. This would mean that the identity of borrowers would have to be known to the lenders and there would need to be a legal framework for DeFi borrowing agreements. We already have chains that support KYC passports that any DeFi app can use, but it will take years for legal frameworks to be created.
Small caveat – a significant portion of bank loans are secured (mortgages, car loans, land…) or in other words, they’re overcollateralized by the initial payment + collateral value. Most DeFi lending applications don’t support these types of collateral yet but there are specialized lending protocols that already support them.
The short answer is no, and this because the two primary usecases for tradfi are borrowing against real-world assets, and refinancing high interest rate debt.
For borrowing against real-world assets (house, business, vehicle, etc.), the penalty for nonpayment is repossession. For refinancing, the penalty for nonpayment is a lower credit rating. Both can lead to involvement with the justice system if debts aren’t repayed.
There’s simply no trustless way to handle this. It’s possible that decentralized legal frameworks could emerge in the future, but any implementation of this would undoubtedly suffer from similar or worse problems. In the meantime, blockchains are a useful tool for studying these sorts of power dynamics.
Take a look at this article:
I made an uncollateralized lending protocol for ETHOnline last year using an identity model pulling from Lens and Coinpassport:
Edit: also, Aave was originally called ETHLend when it was a P2P uncollateralized lending protocol.
Uncollateralised loans is what got us 3AC, Celsius, FTX, Voyageur etc. No thank you. I’m totally fine with using the protocols as they currently exist. Great tools for leverage trading and earning some small lending fees.
DeFi faces challenges in replacing banks without a proper legal framework, especially when it comes to uncollateralized loans. Currently, DeFi relies heavily on over-collateralization to mitigate risks, which limits its potential for mass adoption.
One possible solution to this issue could be the implementation of decentralized identity (DID) and reputation systems. These systems would allow users to build their credit history and reputation within the DeFi ecosystem based on their on-chain activities, while maintaining privacy and data security. It would require a combination of technology and governance to prevent fraud and ensure the integrity of the system.
In addition, a comprehensive legal framework would be necessary to support DeFi’s growth, addressing the enforcement of loan agreements, dispute resolution, and other legal matters. This would involve collaboration between regulatory authorities, DeFi platforms, and legal experts to create a system that balances innovation, security, and compliance.
It’s essential to recognize that DeFi is still a nascent industry, and its growth and maturation will require time and ongoing efforts to address the challenges you’ve mentioned. However, with the right solutions and collaboration, DeFi has the potential to revolutionize the financial sector and offer a more inclusive, efficient, and transparent alternative to traditional banking