Uncollateralized Lending & Borrowing

Overview

Uncollateralized Loans (a.k.a. Unsecured Loans in traditional finance speak) is a loan that is granted to the borrower without the need for the borrower to pledge assets as security for the loan. This stands in contrast to Collateralized Loans whereby borrowers are allowed to borrow up to a specified percentage of the collateral value pledged to the lender. As such, uncollateralized loans require some non-monetary assurance that the borrower will make good on their payments to the lender.

Introduction Of Credit

Historically, uncollateralized loans usually relied on building trust between the borrower and lender. Consequently, lenders had to be sufficiently comfortable with the ability of the borrower to pay back their debt based on what the lender believes about the borrower's future cash flow and ability to manage their financial obligations. As such, the borrower's financial reputation was crucial in determining the terms of the loan. This is what has become known as the borrower's creditworthiness.

A consortium of banks and financial regulators eventually arose to manage the risks inherent in guessing a borrower's creditworthiness. Moreover, formalised loan contracts were created enabling the loan terms to be legally enforced by a judicial system. Increased regulation also reduced the risks of predatory loans whereby loans were extended to borrowers on unfair and deceptive terms (at least on the part of the peer-to-peer lender).

While this system currently facilitates trillions of dollars worth of loans, it suffers from some major drawbacks:

• Unequal Access To Capital: Unbanked users or users with less transaction history as recorded by the traditional finance system will always have a credit rating which is not reflective of their actual trustworthiness. This results in loans being declined or loan volumes being significantly lowered.

• Data Harvesting: The assessment of a borrower's creditworthiness necessitates the collection of significant personal and financial information.

• Non-Standardized Evaluation: Different financial and credit bodies have varying methods to assess a borrower's creditworthiness. Such methods are usually less transparent and not easily understandable.

Flash loans were created as a means for users to get more transparent and equitable access to capital while providing more user privacy.