It’s no secret that peer-to-peer (P2P) lending has a collateral problem. Visit any online forum and you’ll see horror stories from investors who’ve lost money because of borrowers defaulting on loans. Either staked collateral was poorly-valued or illiquid, or there wasn’t any collateral at all.
Loan security is crucial to building confidence in the fast-growing P2P lending industry. At Constant, we believe we’ve found the perfect collateral in the form of digital currencies. Not only are they liquid and borderless, but the market is huge — worth over $200bn.
What are digital assets?
A digital asset is any data you own that has value and can be transferred or otherwise manipulated electronically.
Constant uses cryptocurrencies — a form of digital currency whose ownership, permissions, and transaction history is stored on an unmodifiable public ledger called a blockchain.
Without getting too technical, blockchain is one of the first technologies capable of supporting an electronic money system. After the financial crash of 2008/09, an unknown person or cooperative created the Bitcoin blockchain and the world hasn’t been the same since.
There are now millions of crypto holders around the world. A large percentage of them have bought into their assets as a long term investment. Given the majority of cryptocurrencies are highly-liquid, using them as collateral would all but erase the risk of default.
The problem with P2P lending today
Many P2P lending sites claim to use complex loan assessment algorithms to analyze the risks of borrower default. They claim these are better than traditional FICO-based systems.
But in practice, lending sites will either rely entirely on volunteered financial information or require credit score checks. The same checks that keep borrowers from using traditional lending institutions (like banks).
Traditional institutions have remained a trusted source for investment because they can claim possession of collateral in the case of a default. If a borrower wants to take out a loan for a house, they will usually agree to give the house to the bank if they fail to pay.
By contrast, most P2P lending sites have no real means of obtaining fees for a defaulted loan. Instead, they might:
- Make lenders pay into a pool used to offset default costs.
- Sell off bad loans to buyers for low returns.
- Pursue legal action against a borrower who likely can’t repay.
In almost all cases, investors don’t break even. They’re encouraged instead to offset the risk of default through diversification. But when profits become too fleeting, it becomes time to ask if a service is truly offering real value to users.
Why cryptocurrencies make good collateral
Cryptocurrencies have real-world value.
Modern fiat currencies such as USD are only as valuable as their issuing bodies (usually governments) say they are. Digital currencies have more intrinsic value. Many of them are deflationary, for example, and being decentralized (not controlled by a central body), aren’t susceptible to the vagaries of central banking systems.
Being digital, cryptos are borderless. They can be sent to anyone, anywhere, for next to nothing. This makes them ideal stores of value and effective mediums of exchange.
While some cryptocurrencies have gained a reputation for volatility due to speculation, Constant assures loan security by making all borrowers put up 150% of their loan in crypto. We then give users warnings to top up in the case of a collateral price drop below 110% of an investor's principal plus earned interest to date to make sure the investment stays secure.
Cryptocurrencies have much higher liquidity than other assets.
Physical assets — like property or stock options — have real value but low liquidity. Collecting funds from these assets usually requires a price evaluation, multiple money transfers, and sometimes court action from a debtor. The process can take a long time and investors can end up waiting years to receive any money back from a defaulted loan.
Digital assets are easier to move because they are stored entirely as small pieces of data. They can be easily sold and transferred online in the case of default. Investors can rest easy knowing that they do not have to eat their losses while waiting for compensation for a bad loan.
Constant caps cryptos used on the platform based on factors like liquidity and trading volume, assuring we always have a market for liquidating assets in the case of default. Additionally, we calculate different LTVs (Loan-to-Value ratios) based on similar quality factors so lenders can better assess risk.
Cryptocurrencies are trustless.
Blockchain technology is decentralized, or not run by one central entity. Cryptocurrency transactions are validated by members of the blockchain network, before being added to the permanent transaction record.
We use a combination of crypto wallets, third party custodians (like BitGo), and smart contracts (blockchain programs) to escrow collateral. Constant can automatically move money based on a simple contract fulfillment protocol. When the correct amount of money has been transferred to the lending party, collateral is either released to the borrower or sent back to Constant where it is sold at market value to reimburse the lender (any difference is returned to the borrower and they keep the loan too).
Escrowing collateral eliminates uncertainty for lenders. And it allows borrowers to gain competitive loans without putting their entire financial history out on the internet for everyone to see.
The bottom line
By investing in loans secured by digital assets, investors can participate in the highly profitable P2P lending market without worrying about poor risk-assessment. And lenders can leverage their digital assets to obtain competitive loans without cashing out their investments. Both can be part of a truly secure and trustless process working to benefit all parties.
P2P lending has proven its viability and demand in the modern financial landscape. By finding innovative ways to improve reliability, we are creating a safer and more beneficial environment for anyone looking for a better way to invest.