DeFi is quickly discovering its first growing pains. Low APRs, high risk and terrible user experiences are plaguing its adoption.
To better visualise the problem, we can go on one of the most popular lending markets in DeFi — Compound ETH. Lenders supplying ETH into Compound currently receive 0.07% APY, while borrowers currently pay 2.71% to ETH lenders.
Example: Maia supplies 100 ETH into a Compound pool while Barry borrows 100 ETH. After one year, Barry will have paid 2.71 ETH in interest to the pool, while Maia will only have received 0.07 ETH in interest as a lender.
The delta between what borrowers pay and what lenders receive comes from the suboptimal utilisation of the lending pool.
As lenders pool their money into a market, borrowers utilise less than what has been supplied. One of the most important parameters of any lending protocol is called the utilisation rate which can be described as the ratio between supplied and used funds.
This utilisation rate is always under 100% for borrowers to be able to take out new loans from the pool and for suppliers to be able to withdraw funds. On average, it hovers between 60% and 80%.
The higher the utilisation rate, the smaller the difference between what is paid by borrowers and what is earned by lenders.
Intuitively this makes sense, as in a market with 60% utilisation, lenders only make yield on 60% of their capital. In that case, borrowers have to pay high rates for lenders to receive average returns.
If utilisation rate is 50%, and lenders need to earn 10% yield on the assets they supply, then borrowers have to pay 20% interest. The 50% of funds from the pool being utilised earns 20% from borrowers, and the other half earns 0% since it’s not being borrowed, making the lender’s APY = 10%.
The solution would seem to be 100% utilisation rates across the board. While this isn’t possible with pooled lending solutions (P2C), it’s already happening with P2P lending.
If Barry requests to borrow 100 ETH, a lender can supply exactly that amount and earn interest on 100% of their supplied assets. This represents a much higher capital efficiency for lenders, allowing them to earn more yield with the same amount of capital.
This also helps borrowers pay less interest on average. Indeed, they no longer have to compensate for capital inefficiency of pools when paying interest rates to lenders.
Despite being capital efficient, improved rates in P2P come at the expense of user experience. P2P loans are slow to match supply and demand, and require lots of volume for the market to determine appropriate rates.
Pools are really what allowed DeFi lending to scale, by having instant matching of lenders and borrowers, and creating new forms of passive yield. In this evolution from P2P towards P2C, a great deal of capital efficiency was lost, resulting in unattractive yields across all major protocols
A lot has changed since Compound’s creation of peer-to-contract pools in early 2019.
We now require hybrid solutions to include the best parts of P2P while maintaining the usability of P2C pools. Honey has explored these hybrid solutions in part 1 of our recent Building scalable infrastructure for NFT lending. We concluded that if P2P was built on top of our pools, the capital efficiency of P2P could be introduced into the protocol without disrupting UX.
If provided the ability to refinance loans on a P2P protocol, borrowers can benefit from higher capital efficiency by paying lower interest rates and obtaining higher LTVs. They would borrow instant liquidity from lending pools, then offer their position in a P2P market.
Lenders could opt-in to this capital efficient layer 2 by supplying liquidity to P2C borrowers. This also means the protocol is backed by more liquidity as the demand from P2P lenders allows more debt to be issued per position and per market.
The biggest benefit is for borrowers with rare NFTs, as they can obtain the instant liquidity from the floor price, then borrow more through refinancing.
Pooled lending has to make a tradeoff when appraising NFTs, accuracy vs solvency. The more accurately a pool prices an individual NFT, the less certain its ability to liquidate at that higher price.
Peer-to-Peer refinancing eliminates this tradeoff entirely. Since P2P lenders are both appraisers and liquidators of collateral, they both appraise more accurately and fully secure the liquidation.
Our previous article already covers the benefits of the protocol in terms of liquidity and solvency, so we won’t cover that again here. The TL;DR is that integrating a P2P layer 2 allows LTVs to double while also reducing risk in the protocol, increasing solvency, issuance of debt, and protocol fees.
The Honey P2P layer 2 will offer stakeholders the ability to obtain better rates and better terms on their loans than any other protocol. On average, we can expect this improved capital efficiency to drive more liquidity through Honey, from both lenders and borrowers.
This, along with our new liquidation engine, is at the frontier of what is being done in DeFi today. We encourage those who want to participate in these exciting DeFi experiments to contribute to our open-source code, to build the powerful financial tools of tomorrow’s NFTs.