At the moment DeFi loans are fully collateralized, with the loan to value ratio affecting the interest rate you pay. If your collateral drops in value you have to recollateralize the loan, or are liquidated.
I have been trying to understand this too. Best I can figure, it's basically a short sell on USD.
The key element is that the loan is not denominated in BTC, but a stablecoin pegged to fiat. DAI is one of these pegged 1:1 to USD.
Say you are holding Bitcoin and think it's going to the moon. You tie up your Bitcoin as collateral and take out a loan of roughly 75% of its value, in DAI. Then you spend that DAI to buy more Bitcoins. Now you are exposed to Bitcoin's price movements on two ends: the BTC you bought with your loan, and the BTC you put up as collateral. If Bitcoin's DAI price goes up by more than the interest rate on the loan, you can sell and have more than enough to repay the loan. The extra is pure profit and plus your collateral grew in value in the meantime too, so you're a winner on both fronts.
On the other hand, if Bitcoin's price goes down by too much and you can't repay the loan, your collateral could be liquidated and become property of the lender. You lose everything.
Color me surprised that the amazing decentralized finance, the future of banking, etc. is... yet another way to speculate on "number go up".
DAI is mostly minted from ETH, at a rate of $150 collateral to $100 DAI. https://daistats.com/#/. The $200m DAI minted from WBTC represents 0.02% of Bitcoin's market cap.
Is what I outlined still basically correct in terms of describing the utility of an overcollateralized loan? That is: Use crypto for collateral to borrow stablecoins, to buy more crypto, to make profit (hopefully exceeding loan interest) when the crypto price goes up.
Or do I have that all wrong? I really am not sure that I grok how this works, at all. I'm trying to figure out what is going on in this space and you seem to know a lot more about it than I do. I couldn't figure out another good reason to use an overcollateralized loan but it's clearly something people are interested in and using as a selling point for DeFi.
What actually happens if the borrower defaults on the loan? Do they "just" lose their collateral, or can they be held to account for the DAI somehow too?
If loan repayment is not made, or the collateral falls in value sufficiently that the loan becomes undercollateralized, the collateral will be sold to cover the outstanding debt. The outstanding debt can be invested on a new business, stocks or gold - its not restricted to buying digital assets.
If what you are saying is true then this is literally the housing crisis with variable rate loans and a collapsing market putting everybody underwater. If the value of the item used as collateral sinks then you go from fine to broke in an instant.
But then we are back at the original problem, which is that I have no ability to repossess a nontrivial amount of property to handle a default and this system is explicitly constructed to be outside of the bounds of things like credit scores.
Regarding the auto financing. Traditional lenders will typically have no ability to repossess secured assets themselves, they will send out a colourful letter and if that doesn't work, sell the debt to a collection agent.
DeFi in the form currently available doesn't need a credit score as it is secured against collateral, but a credit score would likely be needed in this case.
New cars sold in the EU are likely trivial to repossess; I believe they have built in location trackers.
Incidentally, it is my hope that once laws change the collateral can be any type of asset, not only digital assets. The collateral could also be some sort of tokenized reputation issued by a collective, whom have decided you are worthy of credit. Perhaps they are affiliated with your employer or have enough knowledge to assess the stability of your income due to their knowledge of your skillset. The lenders would then be paid by them, by proxy - allowing those capable of assessing risk, and those with sufficient funds to lend, to be distinct.
Incidentally, this is all bleeding edge, let's see what is actually built and what works with all this new possibility.