Real-world vs. On-chain lending

Let me start by declaring that I am a massive proponent of blockchain technology and in particular what I think it can do to address the opaqueness and excessive leverage in our current financial system.  

.....That said, last year's events have again made it painfully obvious that we need to be very careful not to re-create that which we are trying to solve.  Whilst the UST/Luna implosion could still be classified as a "failed experiment" in which most people that DYOR could form a view as to the mechanics and likely outcome of volatility/default, things become very murky very quickly if there is off-chain, bilateral (often uncollateralized) lending activity as was the case with 3AC, Celcius and now also with FTX.

The tale is as old as time, it is the reason that certain types of lending are considered riskier than others and require lots of "belts and braces" in the TradFi world. Providing leverage to trading operations (AKA "prime brokerage") is one such risky form of lending and thus usually limited in size relative to total bank balances, requires a relatively high risk-weighting from a capital requirement perspective, and is usually run as an extremely integrated offering together with trading facilities which enable monitoring of trading activity real-time whilst requiring daily settlement/collateralization (all of which I refer to as "belts & braces").

In the real world, there is plenty of less risky, cash flow based, and/or collateralized lending activity to entities that produce income other than solely through the underlying collateral/asset.  But in the crypto sphere, on-chain lending activity is basically all geared toward providing leverage on digital assets for trading purposes, as that is currently the largest source of on-chain income (besides spreads). Collateralized DeFi lending protocols are arguably a good and transparent means of providing such leverage but they offer relatively pedestrian yields (especially from a crypto perspective) as the leverage they can provide is naturally curtailed by the value and volatility of the underlying collateral.

Plenty of experiments have been run to spruce this on-chain yield deficit including but not limited to uncollateralized lending in some combination with inflationary tokenomics and/or yield farming and liquidity mining all logically coming to the same conclusion that you cannot fabricate yield out of thin air indefinitely.

In the real world, the credit spectrum spans all the way from risk-free (government bonds) to High Yield and beyond... Providing, let's call it, low single-digit to low/mid-double-digit un-levered and non-capital-requirement-adjusted yields on average across the credit cycle.

Crypto yields provide a similar spectrum of yields from low single-digit over-collateralized lending yields which are super transparent and subject only to smart-contract and some digital custody/counterparty risk, to yields far exceeding those available in the real world, many of which depend on all kinds of financial leverage and tokenomics wizardry, lack the TradFi "belts & braces" and which those who do not qualify as crypto degens (they/them) should obviously try to avoid at all costs.

So how then do we bring sustainable yields to crypto? I see three practical (less risky) alternatives in order of actionability:

• On-chain composable leverage such as that offered by protocols like GearBox to decentralize yield generation through those that know what they are doing in DeFi trading & yield farming and provides an efficient market for funding them and generating yield
• Connecting Defi liquidity to higher-yielding real-world sources of credit exposure while avoiding leverage and putting as much of the "belts & braces" required on-chain.  This can help address funding shortages in the real world by making the market for them more transparent and accessible on-chain (Centrifuge, Florence Finance, GoldFinch)
• Increase the on-chain economy enabling loans to be made on-chain to companies that generate non-trading-related income and can afford the interest

At Florence Finance we have a soft spot for SMEs and our protocol is aimed at addressing their funding needs but I would be lying if, at times, I was not somewhat jealous of those that went the "easy route" of providing on-chain loans to crypto-native and largely trading focussed counterparts making it far easier to fund and administer the loans as well as raise funding, given the familiarity with and liquidity of the borrowing base.  There are however two good non-SME-related reasons for sticking to our guns:

1. Because crypto native lending activity would do very little to generate non-crypto correlated yield that we believe is necessary to drive crypto adoption through the attraction of more mainstream/conservative savings-oriented users
2. Providing leverage to a sector that has ubiquitous access to cheap funding through tokens seems pointless from a lender's perspective as they would be better off with direct token exposure

To this end, we want to use 2023 to build out Florence Finance's Real world SME lending business to further adoption by proving that crypto can provide valuable and sustainable real-world use cases with an attractive and sustainable risk/reward profile.