New and innovative technologies bring opportunities to the evolving financial sector, and blockchain technology has expanded various possibilities that traditional systems could not offer. One such innovation is the use of ERC-20 tokens for the purpose of taking collateral for availing loans. This effectively links DeFi and regular finance, providing new liquidity opportunities for customers who own assets in the form of cryptocurrencies. Here’s how #erc20 tokens are disrupting loan guarantees and how banks are incorporating this new digital collateral.
About ERC-20 tokens
ERC-20 tokens refer to digital tokens built on the Ethereum network for easy interaction with smart contracts. Since their creation, ERC-20 tokens have emerged as one of the most used asset classes on the Ethereum blockchain for projects that issue digital currencies and express their value by companies. The unique properties of such tokens are that they are digital, transferable and secure, making them suitable for use as collateral across many financial scenarios.
In fact, why should you use ERC-20 tokens or contract tokens as loan collateral?
That liquidity and transparency is why banks are gradually waking up to the fact that they can accept ERC-20 tokens as collateral. Unlike real-world assets, which are very difficult to sell or convert, converting ERC-20 tokens into fiat currency or other cryptocurrencies is actually very easy. Using smart contract technology, these assets can also be coded according to specific conditions, which ensures that banks and borrowers can trust each other throughout the transaction process.
However, since these tokens rely on Ethereum’s blockchain, the entire transaction process can be easily tracked. This, in a way, minimizes fraud incidents, as each transaction is registered and not only the lending company but also the borrowing company can be searched. Due to their inherently high flexibility and liquidity, ERC-20 tokens are considered ideal assets for modern banking systems looking to update their collateral strategies.
How it works: Loan process
In traditional loans, the borrower provides collateral in the form of real estate, gold, stocks, or other types of securities. The same rules apply to ERC20 tokens. Here is a general breakdown of how banks use ERC-20 tokens as loan collateral:
Asset Valuation: The borrower’s ERC-20 tokens are verified using parameters including, but not limited to: price, velocity and volatility. Due to the volatile nature of the value of cryptocurrencies, most banks use haircuts that reduce the value of the token by applying a discount. Smart contract integration: To optimize the process, a smart contract receives ERC20 tokens and releases them only when the loan is repaid in full. Smart contracts trigger actions as soon as or before certain parameters are met, eliminating intermediaries and reducing expenses. Loan terms: The agreement, devised as a smart contract, then determines items such as interest rate, repayment amount, and collateral. During the term of the loan, the borrower’s ERC20 tokens are held in the loan’s smart contract. Collateral release: Once the loan is fully repaid, the smart contract returns the tokens to the borrower. In case of default, the tokens underlying the contract will be sold to ensure that the loan amount is recovered by the bank.
Advantages of using ERC-20 standard tokens as collateral
Enhanced liquidity: Borrowers can now directly fund their operations instead of selling Bitcoin or other cryptocurrencies. $XST can be used to pay for services and goods, and the tokens can also be used as collateral, but they are not tied to investments. Reduced loan processing time: Using smart contracts reduces all the paperwork associated with loans and also minimizes the waiting time for approval. This efficiency is interrelated, allowing borrowers and lenders to access financing almost instantly. Reduced costs: DAOs do not involve intermediaries, which significantly reduces expenses associated with operations such as loan issuance. Accessibility for Crypto Asset Holders: Holders of ERC-20 tokens can obtain capital without liquidity, allowing them to hold equity in risk assets and gain credit at the same time.
Challenges and considerations
Although promising, using ERC-20 tokens as collateral presents challenges, including:
Volatility: There is inherent volatility in the cryptocurrency market, which can affect the value of collateralized tokens. To minimize this risk, banks apply “haircuts” and closely monitor market conditions. Regulatory uncertainty: While some jurisdictions have created structures and guidelines regarding digital assets, others remain unclear and may lead to difficulties in enforcing security interests in digital assets. It’s a factor. Risk of smart contract vulnerabilities: Although smart contracts can be used effectively, they are not perfect. Prima facie, the potential for flaws in contract code and incorrect calculations poses a threat to both borrowers and lenders.
Real-world adoption: Banks and institutions are leading the way
Some financial institutions and crypto-focused banks are already on the right track by offering a number of products using these ERC-20 tokens as collateral. While blockchain startups are pioneering DeFi platforms, the trend is now welcoming traditional banks to partner with blockchain companies. For example, some institutions are partnering with DeFi protocols or directly with custodians to securely manage ERC-20 collateral on behalf of these institutions.
However, banks are already offering multi-collateral digital loans, where ERC20 tokens are linked to other cryptocurrencies or globally accepted traditional currencies, to reduce the risks associated with crypto volatility. The focus is on traditional asset-backed loans.
Future prospects
The general trend of lending via ERC-20 tokens is expected to further surge in the future due to the growth of blockchain and cryptocurrencies. As banks become more comfortable with blockchain solutions and the legal environment becomes more friendly to decentralized ecosystems, ERC-20 tokens could become as prevalent in the lending industry as stocks and real estate today. This innovation is redefining the lending market, bringing new sources of financing to borrowers, and expanding the lending platform for organizations ready to take advantage of cryptocurrencies.
In other words, ERC-20 tokens as loan collateral are a true hybrid of decentralized and traditional finance, not only providing crypto holders with their main value: liquidity and flexibility. Take your banking concept to the next level. When it comes to technology and regulation, lending based on digital assets is gradually becoming a reality and has the potential to reshape this type of lending.
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The views expressed above are the author’s own.
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