Can DeFi Lending Achieve True Capital Efficiency? What DeFi Borrowers and Lenders Need to Know

Just three years ago, there were only a handful of DeFi lending platforms, some of the notable protocols in the pioneer wave include Maker DAO and Compound. Today, the number of projects building in this DeFi niche has grown significantly, giving rise to more capital efficient decentralized money market protocols such as Dolomite. According to DeFi Llama, there is currently over $33.8 billion locked across various DeFi lending protocols. 

But amidst this growth, there are nuances that some stakeholders or rather investors seem not to be fully convinced about: Is full functionality of collateralized assets genuine, or is it too good to be true? Let’s start by highlighting the major utilities of collateralized digital assets before we can answer this question. 

The Value of Collateralization in DeFi 

Similar to traditional finance, the whole idea of collateralization is aimed at making credit or liquidity accessible by placing a specific asset as collateral. However, in the case of DeFi lending protocols, the process is fully automated through smart contracts. This means that potential lenders or borrowers do not have to engage a third party. 

For example, assuming an investor owns some ETH and is optimistic that the price will trend higher, but they happen to be in need of stablecoins to execute other DeFi operations; they can seamlessly use the ETH as collateral on Maker DAO to access the DAI stablecoin, which in turn provides them the liquidity they need without having to sell their ETH holdings. 

It is a typical lending and borrowing market given that lenders who are not looking for a loan or liquidity also have the option to deposit their ETH and earn a passive yield. But more importantly, digital asset collateralization means that the lenders or borrowers do not have to give up ownership of their holdings unless when a liquidation event is triggered. 

The pressing question however is whether a simple lending and borrowing market achieves the goal of maximum capital efficiency? Can DeFi users earn a passive yield from their collateralized assets beyond the interest rates offered to lenders or the utility that comes with accessing stablecoin liquidity as a loan?   

How Capital Efficiency Can Transform DeFi Lending  

Although still a fairly new concept in DeFi, any investor would want their capital to yield as much returns as possible. Imagine a situation where the digital assets deposited in a specific DeFi platform can be reused or recycled in more than one way to generate multiple sources of yield simultaneously. That’s the main purpose of capital efficiency! 

There are quite a number of DeFi projects that are building solutions in this line, including the prominent restaking protocol, Eigen Layer. This DeFi innovation allows ETH stakers to leverage their already staked ETH for additional uses across multiple DeFi, scaling, and infrastructure DApps, all while continuing to secure the Ethereum network. 

Restaking is a good example of a capital-efficient model that opens up an opportunity for the stakers to generate some extra yield for contributing towards the support of DApps that would have otherwise struggled to secure their ecosystems or validate on-chain operations. 

Back to the DeFi lending market; while it is a hot topic of debate, novel DeFi protocols such as Dolomite are launching more capital efficient solutions compared to what we have seen in the past. This decentralized money market protocol leverages a virtual liquidity system and isolation mode feature, enabling DeFi lenders and borrowers to allocate their capital in the most efficient manner. 

Dolomite’s virtual liquidity allows DeFi users to transfer or exchange tokens internally hence eliminating the need for one to liquidate their holdings or collateralized assets if they wanted to perform a simple function like swapping. 

For instance, during the infamous USDC depeg event in March 2023, users with USDT collateral in AAVE couldn't withdraw liquidity as all USDT was being used to lever up and purchase de-pegged USDC. Dolomite’s internal liquidity would have allowed users to swap or borrow virtual USDT internally, facilitating withdrawals and maintaining lower interest rates.

The isolation feature is also a game changer in capital efficiency given that it provides DeFi users with the flexibility to limit or expand the functionality of their deposited assets. Notably, one can choose to allow the assets held as collateral to continue performing native functions such as on-chain voting as well as capturing the rewards from the ecosystems where they were initially created or minted. 

This decentralized money market protocol is just an example of what an efficient DeFi lending market should entail. Most importantly, DeFi users ought to be able to reuse their liquidity not just for passive income but also retain critical rights associated with their tokens. 

Conclusion 

As the DeFi market enters the next era of adoption, savvy investors will likely be on the lookout for factors that stand out or maximize the use of their idle capital. It therefore goes without saying that upcoming DeFi innovations ought to pay close attention to models that make the most use of the little liquidity that is currently available. 

This is what tradfi investors scout for, and if any liquidity is to come from them, it is probable that their investment approach will be based on maximum capital efficiency. After all, it is only fair for a market currently pricing a high volatility premium amongst other uncertainties.