The risks and rewards of paying off student debt on the blockchain

The risks and rewards of paying off student debt on the blockchain thumbnail

Robin Kim graduated from New York University in 2015 with a degree in economics. He borrowed more than $100,000 from the US government and quickly became locked in to high interest rates. Since then, he has been trying to repay his student loans.

Kim eventually refinanced his student loans through a private lender to lower his interest rate. But he was curious if there were other options. “I was paying $1,500 a month, every month, to pay off this loan,” he says. “That amount could have been better spent elsewhere.”

A former engineer at Coinbase and a cofounder of Gallery, an online platform people can use to curate and share their NFT collections, Kim had thought of selling cryptocurrency to pay off his loans. He would have to pay taxes on any profits he made if he did this.

Kim instead took out a loan through Aave ,, a lending portal built on the Ethereum blockchain. He used the money to pay off his debt and is now working towards repaying the loan.

How does DeFi loans work?

Decentralized finance is a general term that refers to blockchain applications that are used to create complex financial products. DeFi loans are not tied to traditional banking systems. They often have lower interest rates and do not affect credit scores. In theory, DeFi loans can be held indefinitely.

DeFi loan can be based upon any digital currency. That includes stablecoins, which are cryptocurrencies whose value is tied to external sources like the US dollar. To obtain a DeFi loan, borrowers will first need to deposit collateral in the form crypto assets that are worth more than the amount they want to borrow. The lender will determine how much more you can borrow. It’s a bit like putting down $100 in one currency to borrow $75 in another.

The borrower receives the loan, such as stablecoins. These can then be exchanged to US dollars. The money is used to pay off a loan and then the borrower pays off the DeFi loan in order to reclaim the collateral.

DeFi comes with its own risks. If the collateral of a borrower drops below the loan amount, it can be liquidated. Despite having greater market liquidity than any other cryptocurrency is still highly volatile , with its value fluctuating by an average of 3 percent per day. Borrowers can lose their collateral if prices fall too much. (Though, borrowers are less likely to lose collateral if the collateral’s value appreciates. )

Stablecoins have also been the target of government scrutiny, given the risks of an unregulated stablecoin market to the global economy. Regulators warn that volatility in value could cause widespread losses for stablecoin holders, and potentially destabilize the entire financial system.

In November 2021, a US government working group recommended that Congress require stablecoin issuers to be subject to the same regulations as banks. In February, US Representative Josh Gottheimer, a New Jersey Democrat, announced the Stablecoin Innovation and Protection Act, which would issue government-backed insurance for stablecoins. These steps would reduce volatility, but a government backed coin would not be decentralized.

Another major risk is that smart contracts, the automated agreements underwriting loans on the blockchain, are not infallible. Smart contracts are executed based on predetermined conditions that have been written into code. This code is written by humans and could be hacked or misspelled.

It is a matter of trust

Borrowers should therefore have a lot of faith in the platform that issues their loan. Security measures can be taken by more prominent platforms to reduce risk. For example, the platform Compound Treasury‘s community has hired security firms to evaluate its loan protocol to make sure its code is secure.

“Even so, it’s really up to the end user, the developer, and the borrower or lender to really assess the stability and riskiness of the smart contract,” says Reid Cuming, Compound’s vice president and general manager. “I think we’re still in a state where there’s a lot of room for improvement here.”

Anyone who knows your wallet address can see how much you borrowed.

DeFi platforms also provide little privacy to borrowers, meaning anyone who knows your wallet address can see how much you borrowed and when.

Crypto skeptic Molly White said that this divides users into three groups: people who want to protect their privacy but are unable to use major crypto platforms; people who don’t mind sharing some of their identities with the public; and people whose identities or crypto wallets are publicly linked.

As the choice of platforms comes down to liquidity versus privacy, many of the purported benefits of decentralization–privacy, anonymity, and independence from corporations–no longer apply. These risks require technical expertise that most borrowers don’t have.

On one hand, White says, some believe these platforms are making financial transactions, once the domain of experts, available to anyone–“but on the other hand, people are getting sucked into making risky decisions that they don’t have the knowledge to be able to make responsibly.”

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Kim remains optimistic. White compares the situation with the early days of the internet, and says that DeFi has the potential for mainstream success, despite the risks. “I believe DeFi will be parity with central finance… because of its transparency and openness,” he said. “The ecosystem does have to mature, but I think that’s the case with any emerging technology.”

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