One of the main tenets of decentralized finance and crypto, in general, is providing access to financial systems and wealth for the under-served. In the current DeFi scene, most protocols require you to over-collateralize any loans you take out. To put it simply, to take out a loan, you must lock up more in assets than the amount you want to borrow. This is typically considered a good idea when loaning out money to strangers on the internet, but for most people who need a loan, it usually isn’t the case that they have several thousand worth of crypto assets. When Aave rolled out version 2 of its protocol, it introduced pseudo-uncollateralized loans through trusted credit delegation. This allows users who are lending their crypto through Aave but are not using their line of credit to set up credit delegation vaults and permit others to take out loans against the delegator’s credit.
How this looks in practice is someone, let’s say Alex, deposits crypto into Aave and receives aTokens in return. They then take those aTokens to set up the Credit Delegation Vault with the details such as the borrowing limit and interest rate. Then, Alex enters into an agreement with Bob, who wants to borrow. They write their contract up via OpenLaw, a platform that allows the tying of legal agreements with executable Ethereum code, and Bob’s address is whitelisted by Alex. Bob can then borrow crypto from the vault up to the predetermined limit without having to post any collateral at all. So while the collateral is still there, it isn’t provided directly by the borrower.
While not perfect, this is a big step in innovation in the decentralized finance sector as it opens crypto borrowing up to those who don’t have the crypto assets to post collateral while also allowing previously unused credit to be utilized. The lender is able to earn extra returns for taking on increased risk, and more liquidity is added to the market. This is logically the next step for other protocols like Compound, and it wouldn’t be surprising if we see some form of this eventually make its way into use through innovative CeFi companies like Celsius or Nexo as well.
The downside is that it isn’t entirely trust-less. The delegator needs to be able to trust that their borrower will honor the OpenLaw agreement as written and not just disappear, most likely through some form of KYC or identity verification. This problem could also be solved through other innovations like crypto-insurance to cover the risk of your delegation pool or some sort of crypto wallet credit score.
Ultimately this is a move in the right direction for the entire DeFi space. Opening up more liquidity and incentivizing lenders to derive further value from their holdings will help drive further adoption and encourage more innovative solutions for market needs. This development also shows why Aave is and will continue to be an important player in decentralized finance and the crypto space as a whole.
Cheers and thanks for reading!