What is DeFI lending?
DeFi lending is a type of lending that operates on a blockchain network and allows individuals to lend and borrow digital assets without the need for intermediaries such as banks or financial institutions.
DeFi lending platforms allow users to lend their cryptocurrency assets and earn interest on their deposits, while borrowers can take out loans against their cryptocurrency assets as collateral. The lending and borrowing rates are determined by supply and demand, and there is no central authority that sets the rates.
In DeFi lending, loans are made using smart contracts, which are self-executing contracts with the terms of the agreement between the lender and borrower written into code. The smart contract ensures that all parties involved in the lending process comply with the agreed-upon terms and conditions without the need for intermediaries such as banks or financial institutions.
Here’s how loans are typically made in DeFi lending apps:
- A borrower deposits cryptocurrency assets into a smart contract as collateral. The amount of collateral required depends on the platform and the specific asset being used as collateral.
- The smart contract verifies the borrower’s collateral and sets the loan terms, including the interest rate, repayment schedule, and any penalties for default.
- The lender deposits cryptocurrency assets into the smart contract, which are then made available to the borrower as a loan.
- The borrower repays the loan according to the agreed-upon terms, including interest and any other fees.
- Once the loan is fully repaid, the borrower’s collateral is released from the smart contract and returned to them.
Throughout the lending process, the smart contract automatically handles the transfer of cryptocurrency assets between the borrower and lender, ensuring that all transactions are secure and transparent. This automation eliminates the need for intermediaries, reduces costs, and increases efficiency, making DeFi lending a popular alternative to traditional lending.
While many lending platforms have disappeared in recent years due to regulatory uncertainty, some popular platforms remain, including:
- Aave: Aave is a DeFi lending platform that allows users to lend and borrow cryptocurrency assets. It operates on the Ethereum blockchain and supports a wide range of assets.
- Compound: Compound is a decentralized lending and borrowing platform that allows users to earn interest on their cryptocurrency assets and also borrow cryptocurrency by providing collateral.
- Nexo: Nexo is a centralized lending platform that allows users to earn interest on their cryptocurrency assets and also borrow cryptocurrency at low rates.
U.S. Federal Regulation
In the United States, cryptocurrency lending platforms may be subject to Money Services Business (MSB) registration with the Financial Crimes Enforcement Network (FinCEN), a bureau of the US Department of the Treasury that is responsible for enforcing anti-money laundering (AML) and counter-terrorist financing (CFT) laws. MSB registration is required for businesses that engage in certain financial activities, including money transmission, which is broadly defined to include the transfer of virtual currencies. Cryptocurrency lending platforms that facilitate the transfer of virtual currencies may be considered money transmitters and thus subject to MSB registration with FinCEN. Generally speaking, considering the each with which one can accomplish MSB registration, it is advisable to register as a MSB provided the lending platform is able to administer a robust AML/KYC program.
In addition, there are a number of consumer protection laws that may impact DeFI lending platforms, including the Truth-In-Lending Act (TILA). TILA is a federal law that requires lenders to provide certain disclosures and protections to consumers who borrow money, including information about the terms and costs of the loan. TILA applies to “creditors,” which are defined as “any person who regularly extends consumer credit that is subject to a finance charge or is payable by written agreement in more than four installments.” Whether a DeFI lending platform itself could be considered a “lender” has not been determined or challenged in any court. However, one would argue that the peer-to-peer, smart contract-driven nature of such platforms would likely fall outside the definition of a “creditor.”
U.S. State Regulation
The requirement for state lending licenses for cryptocurrency lending platforms in the United States can vary, depending on the specific activities and jurisdictions involved. However, some states may require cryptocurrency lending platforms to obtain a lending license or comply with other lending-related regulations. For example, some states have specific lending laws and regulations that may apply to cryptocurrency lending platforms, such as interest rate caps, licensing requirements for lenders, and consumer protection laws. In those states, cryptocurrency lending platforms that provide loans to residents of those states may be subject to those laws and regulations.
Thus, whether a DeFI lending platform would require a state lending license requires a state-by-state analysis as well as the size of the loan and interest rates assessed. Notably, the nature of the loan being made – consumer or commercial, will also weigh heavily on the need for a license insomuch that most states do not require a license for commercial loans. A quick state-by-state overview of lending license requirements follow:
| Alabama |
| The State of Alabama Small Loan Act, in relevant part, provides that “[n]o person shall engage in the business of lending in amounts of less than one thousand five hundred dollars ($1,500) and contract for, exact or receive, directly or indirectly, on or in connection with any such loan, any charges whether for interest . . .” |
| Alaska |
| The State of Alaska Small Loan Act, in relevant part, provides that a “license is required for the business of making loans up to $25,000 at an interest rate greater than otherwise permitted by law for non-licensees. . .” |
| Arizona |
| The State of Arizona Consumer Lenders Act, in relevant part, defines a “consumer loan” as “the direct closed end loan of money in an amount of ten thousand dollars or less that is subject to a finance charge . . .” |
| Arkansas |
| The State of Arkansas defines a “consumer loan” as “an extension of credit for personal, family, or household purposes but does not include credit card debt, open account debt, or installment loans.” |
| California |
| The State of California Financing Law defines a “finance lender” as “any person who is engaged in the business of making consumer loans or making commercial loans.” Cal Civ. Code § 22009. However, a consumer loan contemplates the imposition of “Charges include any profit or advantage of any kind that a licensee may contract for, collect, receive, or obtain by a collateral sale, purchase, or agreement, in connection with negotiating, arranging, making, or otherwise in connection with any loan.” |
| Colorado |
| The Colorado Consumer Credit Code defines a “loan” as the “creation of debt by the lender’s payment of or agreement to pay money to the consumer or to a third party for the account of the consumer . . .” |
| Connecticut |
| The State of Connecticut Banking Law requires a license in order to make a loan “and charge interest greater than 12% . . .” |
| Delaware |
| The State of Delaware defines an extension of consumer credit to include “any rate agreed upon” |
| District of Columbia |
| The District of Columbia requires a license where a lender is engaged in the “business of loaning money at more than 6% . . .” |
| Florida |
| The State of Florida Consumer Finance Act defines a “consumer loan” as “consumer finance loans,” defined as those of $25,000 or less at interest rate over 18% . . .” |
| Georgia |
| The State of Georgia Industrial Loan Act requires a license for “lenders making loans of $3,000 or less at interest rates over 8% simple interest . . .” |
| Hawaii |
| The State of Hawaii requires a license in order to “make loans at rates in excess of those permitted by other law . . .” |
| Idaho |
| The State of Idaho defines a “regulated consumer loans” as those payable in at least two installments or for which a finance charge is imposed. |
| Illinois |
| The State of Illinois Consumer Installment Act License required to engage in the business of making loans of $40,000 or less at interest rates higher than could be charged without a license. |
| Indiana |
| The State of Indiana Uniform Consumer Credit Code requires a license for loans charging interest in excess of 25%. |
| Iowa |
| The Iowa Regulated Loan Act requires a license “to make loans of $54,600 or less (adjusted for inflation) at rate greater than a non-licensee could charge . . .” |
| Kansas |
| The State of Kansas Uniform Consumer Credit Code requires a license to engage in the business of making supervised loans (ones in which APR exceeds 12%) . . .” |
| Kentucky |
| The State of Kentucky Financial Services Code imposes a license requirement in order to engage in the business of “making loans of $15,000 or less at rate of interest greater than otherwise permitted by law . . .” |
| Louisiana |
| The State of Louisiana Consumer Credit Law defines a “consumer loan” as “a loan of money or its equivalent made by a supervised financial organization, a licensed lender, or lender in which the debtor is a consumer, and the loan is entered into primarily for personal, family, or household purposes and includes debts created by the use of a lender credit card, revolving loan account, or similar arrangement, as well as insurance premium financing . . .” |
| Maine |
| The State of Maine Consumer Credit Code requires a license to make loans charging interest in excess of 12.25%. |
| Maryland |
| The State of Maryland Consumer Loan Law specifically exempts from a license requirement any extension of credit “which does not exceed $6,000, where “extension of credit” is to include a finance charge such as interest. |
| Massachusets |
| The State of Massachusetts Small Loan Action exempts from a license requirement any extension of credit “which does not exceed $6,000 . . .” and where “extension of credit” is defined to include a finance charge such as interest. |
| Michigan |
| The State of Michigan Regulatory Loan Act requires a license “to make loans at rate higher than non-licensee can charge . . .” |
| Minnesota |
| The State of Minnesota Regulatory Loan Act defines a “consumer short-term loan,” as a loan which “has a principal amount, or an advance on a credit limit, of $1,000 or less and requires a minimum payment within 60 days of loan origination of more than 25% of the principal balance . . .” |
| Mississippi |
| The State of Mississippi Small Loan Regulatory Law and Small Loan Privilege Tax Law defines a loan “that is made to individuals primarily for personal, family or household purposes . . .” |
| Missouri |
| The State of Missouri Consumer Loan Act defines a “consumer installment loans” as a “secured or unsecured loans of any amount and payable in at least four substantially equal installments over a period of at least 120 days . . .” |
| Montana |
| The State of Montana Consumer Loan Act requires a license in order “to engage in business of making consumer loans in any amount for compensation . . .” |
| Nebraska |
| The State of Nebraska does not require a license where “the interest rate does not exceed 16% . . .” |
| Nevada |
| The State of Nevada Installment Loan & Finance Act requires a license “to engage in business of lending, except for deferred deposit loan services, high interest loan services (those charging APR of more than 40%) . . .” |
| New Hampshire |
| The State of New Hampshire Installment Loan Act License requires a license “to engage in business of making small loans, i.e., those with finance charges greater that 10% . . .” |
| New Jersey |
| License required to engage in consumer loan business, i.e., make consumer loans of $50,000 or less at rates greater than a non-licensee may charge. |
| New Mexico |
| The State of New Mexico Small Loan Act defines an “installment loan” means a loan in an amount less than or equal to five thousand dollars ($5,000) that is to be repaid in a minimum of four substantially equal payments of principal and interest to pay off a loan in its entirety with an initial stated maturity of not less than one hundred twenty days to maturity . . .” |
| New York |
| The New York Banking Law Statute prohibits any entity other than a licensee from charging interest greater than the otherwise legal rate. |
| North Carolina |
| The State of North Carolina Consumer Finance Law requires a license “to engage in business of lending in amounts of $15,000 or less and contract for charges greater than permitted by the state’s general usury law . . .” |
| North Dakota |
| The State of North Dakota requires defines a “precomputed loan” as a “loan that is expressed as a sum comprising the principal and the amount of the loan finance charge computed in advance . . .” |
| Ohio |
| The State of Ohio Short Term Loan Act requires a license “to engage in business of lending money in amounts of $5,000 or less and charge interest and charges greater than amount that would be allowable for unlicensed lender . . .” |
| Oklahoma |
| The State of Oklahoma Uniform Consumer Credit Code defines a “consumer loan” to include “a loan made by a person regularly engaged in the business of making loans in which (1) the debtor is a person other than an organization; 70 (2) the debt is incurred primarily for a personal, family or household purpose; (3) either the debt is payable in installments or a loan finance charge is made . . .” |
| Oregon |
| The State of Oregon Consumer Finance Act defines a “consumer loan” to be “a loan that is unsecured or secured by personal or real property and that has periodic payments and terms longer than 60 days . . .” |
| Pennsylvania |
| The State of Pennsylvania requires a license to engage in the business of making loans of $25,000 or less and charge more than would be permitted without a license. |
| Rhode Island |
| The State of Rhode Island defines a lender to “include any person engaged in a transaction whereby the person makes or funds a loan within this state using the proceeds of an advance under a line of credit over which proceeds the person has dominion and control and for the repayment of which the person is unconditionally liable . . .” |
| South Carolina |
| The State of South Carolina Consumer Protection Codes requires a license to make consumer loans exceeding 12% interest. |
| South Dakota |
| The State of South Dakota defines a loan as “any installment loan, single pay loan, or open-end loan . . .” |
| Tennessee |
| The State of Tennessee Industrial Loan and Thrift Company Act requires a license where “a person engaged in the business of making loans and imposing the interest and loan charges authorized under this chapter . . .” |
| Texas |
| The State of Texas Finance Code requires a license to “engage in business of making, transacting, negotiating, collecting, or servicing loans subject to the chapter, or to charge interest greater than that otherwise authorized . . .” |
| Utah |
| The State of Utah Consumer Credit Code defines a “creditor” to mean “ (i) a party:(A) who regularly extends consumer credit that is subject to a finance charge or is payable by written agreement in more than four installments, not including a down payment . . .” |
| Vermont |
| The State of Vermont Licensed Lender Law requires a license in order to “engage in the business of making loans of money, credit, goods, or things in action and charge, contract for, or receive on any such loan interest, a finance charge, discount, or consideration therefor . . .” |
| Virginia |
| The State of Virginia Consumer Finance Act provides that “no person shall engage in the business of making loans to individuals for personal, family, household, or other nonbusiness purposes, and charge, contract for, or receive, directly or indirectly, on or in connection with any loan interest, charges, compensation, consideration, or expense that in the aggregate is greater than the interest permitted by § 6.2-303 . . .” |
| West Virginia |
| The State of West Virginia Consumer Credit and Protection Act defines a “loan” to include includes “[t]he creation of debt by the lender’s payment of or agreement to pay money to the consumer or to a third party for the account of the consumer other than debts created pursuant to a seller credit card . . .” |
| Wisconsin |
| The State of Wisconsin Consumer Act defines a “consumer loan” to be “ a loan made by a lender to a customer which is payable in installments or for which a finance charge is or may be imposed . . .” |
| Wyoming |
| The State of Wyoming Consumer Credit Code defines a “consumer loan” to include a “debt is payable in installments or a loan finance charge is made . . .” |
The nature of Decentralization
Finally, the nature of most DeFI lending platforms – smart-contract drive DAOs, may also impact the regulations to which the DAO’s actives are subject to. The regulatory landscape for DAOs is still evolving, and it’s unclear how regulators at the federal and state level will apply existing laws and regulations to these organizations. To date, nearly all legal challenges to the DAO structure have come in the securities law arena. However, such cases are instructive and may ultimately provide guidance for all DAO related activities.
Conclusion
There is a great line from the 80’s comedy Fletch:
Frank Walker: Who’s the source?
Fletch: Well, there we’re in kind of a “grey” area.
Frank Walker: How grey?
Fletch: Charcoal?
Indeed, the regulatory landscape for the regulation of DeFI lending platforms in 2023 is charcoal. Out of an abundance of caution, yes, obtaining MSB registration and state-level lending licenses is perhaps the correct way to go, but it comes at a significant cost and there is obviously no guarantee that a platform would in fact be able to obtain the license in the first place.
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About Adam Tracy
Adam Tracy is a payments expert and entrepreneur who specializes in payment systems, blockchain technology, digital currencies, and other emerging technologies. He is the founder of Blockrunner, LLC that provides consulting services to clients in the blockchain, payments and cryptocurrency arenas.
Tracy has been involved in the payments industry as an attorney, consultant and entrepreneur since 2005, while he was become an expert in blockchain and cryptocurrency since its advent in 2013. Tracy has worked with a wide range of clients, including startups, established businesses, and investor – both in the United States and worldwide. He has advised clients on a wide range of compliance, legal and operational issues related to payment transfer systems, crypto token generation and architecture, cryptocurrency exchanges, regulatory licensing, smart contracts, and other blockchain applications.
In addition to his consulting work, Tracy has founded several companies in the payments, blockchain and cryptocurrency space, including a digital asset hedge fund, licensed electronic money institution and a blockchain-based tokenization platform. He is also a proponent of decentralized finance (DeFi) and has been involved in various DeFi projects.
Tracy is also a frequent speaker and writer on blockchain and cryptocurrency topics. He has been featured in a wide range of publications, including Forbes, CoinDesk, and Bitcoin Magazine.
Find Adam: https://linktr.ee/adamtracy
(Nothing herein shall be construed as legal advice)