Comparing Fractional Reserve Lending Infrastructure Banks Use vs. Collateralized Digital Asset Lending Via Protocol

Comparing Fractional Reserve Lending Infrastructure Banks Use vs. Collateralized Digital Asset Lending Via Protocol

Ben Knaus

Ben Knaus

MELD Ambassador

February 15, 2022

Most people don't know the intricacies of the banking system, and with good reason. Liken it to enjoying a hot dog at a cookout but not wanting to know how the hot dog is made. 

Flashback to March 2020, amid the COVID-19 crisis, all eyes were on the American political system for their $2.2 Trillion COVID-19 relief package (CARES Act). One provision in an early draft of the Bill called for a digital dollar. I noticed lots of rants on social media complaining about this. If only they knew the money in their bank account was already just kept on a ledger, and the bank actually doesn't house those dollars in your account. 

Banks have always been required to hold reserves against their assets, which are loans and securities. Banks set aside a part of their assets into cash at the Federal Reserve or throughout history Gold. In theory, the reserves should give the borrowers confidence that liquidity is accessible when needed. However, in times of financial crisis, last seen in the 2008 'Bank Runs,’ some banks imposed withdrawal limits.

Throughout FED's first 50 years, including the great depression, the reserve ratio was more than 20%. The reserve ratio then made its way to 10% until March 2020, when the reserve rate was cut to a mind-bending 0%. That's right; your bank is not required to hold any reserves. All the while, people scoffed at the idea of the digital dollar. Behind the scenes, they already had it. 

Fractional Reserve Lending 

The weakness of fractional reserve lending is that it's fundamentally unstable without the engineering of central banks and governments. All depositors are promised their money is safe and sound and is liquid upon demand. However, the reality is their funds are sitting on bank balance sheets via securities and loans.

Enter most banks in the US, and you'll see the FDIC, Federal Deposit Insurance Commission, logo on their front doors. This symbolizes that the Federal reserve insures amounts up to $250,000 per depositor, per insured bank, for each account ownership category. 

With the FDIC badge posted in their windows, banks conceptually have no market incentive to exhibit that they're good shepherds of depositor money. So rather than worry about the fiduciary responsibility of a comptroller over their funds, most customers are likely more worried about cute puppies or kittens they can get on their debit card or check blanks. 

Another pitfall of fractional reserve lending is giving the private banking systems significant control over the money supply. If banks lend more, there's more money into the money supply. If they lend less, there's a contraction in the money supply. The issue with this is that in a recession, standard monetary policy argument would say you want to increase the money supply just as the FED did in 2020, lowering interest rates to attract more borrowers, etc... The reality is during a recession; the private banking system tends to approve far fewer loans, especially during periods of default by existing borrowers; you'll always have less lending. With less lending, you have less money in circulation. 

The opposite is true in a boom. Central banks will alleviate some of the overheating markets by selling securities they own and taking that cash out of circulation. However, banks tend to get less risk-averse, resulting in more lending when markets are already overheated—adding more money to a system that's already overheated. 

The fractional reserve lending system often leads to the money creation process going in the exact opposite direction that you want it to go if you want to moderate the fluctuations in the economy for stability.

Collateralized Loans

Collateralization is the use of a valuable asset to secure a loan. If the borrower defaults on the loan, the lender may seize the asset and sell it to offset the loss.

Collateralization of assets gives lenders a sufficient level of reassurance against default risk. It also helps some borrowers obtain loans if they have poor credit histories. In addition, collateralized loans generally have a substantially lower interest rate than unsecured loans. 

A vehicle loan and a mortgage on a house are two common examples of collateralization. The lender may seize the vehicle or the home if the borrower defaults on the payments.

Collateralization is very common for business owners who may put up equipment, property, digital assets, stock, or bonds to secure a loan needed to expand, enhance or improve the business.

The principal amount available in a collateralized loan is generally based on the appraised collateral value of the property. Most secured lenders will loan about 60% to 90% of the value on vehicles or properties and 50% on digital assets.

Collateralized loans are inherently safer than non-collateralized loans, and therefore generally have lower interest rates. Non-collateralized, or unsecured, loans include credit cards and personal loans.

Crypto collateralized loans

Collateralization works the same with crypto loans. For example, say you have 1 Bitcoin worth $40,000 USD. You can borrow up to 50% of the value in a loan (LTV) which is 20,000 USD.

Approval usually requires a simple KYC submission and depositing your asset into a lending platform or locking it in a smart contract. No credit score or income verification is required. 

You keep control of your bitcoin, choose the loan term, and the interest rate is linked to how much LTV you access. Therefore, you can unlock the value of your Bitcoin without creating a taxable event and allowing you to hold a long position into the future. This LTV will fluctuate with the value and price of the asset. If your asset price falls below the required LTV amount, you will receive a margin call to add more liquidity or pay down a portion of the loan. MELD's strategy for handling LTV and margin calls will account for fluctuations that are common with cryptocurrencies.

The opposite is also true if your LTV falls, you're able to borrow more from your asset. I've personally used a crypto loan in the past to experience DeFi first-hand. I got a 40% LTV at 1% interest funded in under 24 hours. 

Some like to scoff at the idea of borrowing against what they deem a "highly volatile" asset. However, if you look at Bitcoins' decade-plus history and compare the annual lows for the asset, only one year didn't see geometric growth from the previous year's low. Thus, evaluating the geometric growth of an asset by the annual lows gives you a solid trajectory of its growth. 

Many people would rather borrow from a protocol operating on a decentralized blockchain free of a central point of failure, with immutability. The lending process becomes quick and easy. You can take a loan out while sitting on the beach, not having to make small talk with an account manager at a bank hoping underwriting will approve you.  

 

KEY TAKEAWAYS


  • Collateralization provides a lender with security against default on a loan.
  • Fractional reserve lending is a tumultuous cycle that inversely affects what traditional monetary theory preaches.
  • Collateralized loans greatly reduce the lender's risk, and the interest rates on collateralized loans are substantially lower. With crypto loans, interest rates are often 1%-9%. 
  • Credit scores and income don't come into play with crypto loans.
  • Turnaround on crypto loans is generally 1-2 days from start to finish.

Disclaimer

The opinions shared within this article are those solely of the MELD Ambassador. Note that the content within should not be considered financial, legal, or tax advice. Neither the author nor MELD Labs PTE Ltd. are financial, legal or tax advisors. None of this content should be used to make any form of financial, tax, or legal decisions. Do your own research and consult professionals as needed for official policies, restrictions, and requirements in your jurisdiction.

If you believe in the MELD vision, want to support this initiative, and want to help promote the future of finance then we want you to join the MELD Ambassador Program!

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