Goldfinch Finance: Lending at Global Scale

Disclosure: I have contributed to the Goldfinch protocol as a founding team member of Warbler Labs and as an investor through Stratos Technologies.

Goldfinch.Finance is a decentralized lending protocol built on the Ethereum blockchain, and in my view has as much potential to disrupt traditional finance as any project in crypto/Web3. Here’s why I think so.

On November 30th 2021, the Goldfinch platform funded a $10 million dollar loan to borrowers based in South America, India and Africa, with no interaction from a single decision maker — the loan was sourced, underwritten, and funded in a completely decentralized way. 141 members of the Goldfinch community, known as “Backers”, funded $2.5 million in a junior tranche, and the “senior pool” algorithmically funded the remaining $7.5 million. There were over 30 countries of residence for the 141 backers — a truly global transaction, facilitated seamlessly. By the end of 2022 multiple transactions of this kind will be occurring simultaneously on the Goldfinch platform, from lenders on one continent to borrowers on another, 24 hours a day 7 days a week.

The Goldfinch community has built the world’s first global decentralized credit marketplace connecting investors looking to earn yield and borrowers seeking capital to put to productive use. Neither of these desires are new; this basic arrangement has existed for thousands of years — where the Goldfinch protocol is truly novel is in its capacity to serve investors and borrowers anywhere in the world, and thus at a scale never before achieved in finance.

There are many aspects of Decentralized Finance “DeFi” that are promising and represent improvements over traditional finance. The one that stands out most in the context of lending is the ability to deploy capital globally, without the arbitrary constraints of localized capital markets.

Why now?

As more capital has entered the Decentralized Finance “DeFi” ecosystem, lending yields have declined. In mid 2019, total cryptodollar stable coins outstanding were less than $1 billion, and lending rates on Compound (a leading collateralized lending protocol) were at times above 20%. Today, there are over $100 billion in cryptodollars outstanding and lending rates are consistently below 4%. This trend will accelerate as institutional capital continues to flow into DeFi.

Compound, Aave, and Yearn will continue to dominate the collateralized lending markets for nearly risk-free lending (think of this like a money market fund in traditional finance), but we will see the yields they offer to investors decline and likely converge with traditional finance money market rates, which is to say near zero.

These collateralized lending protocols are brilliant designs and represent key financial primitives that enable the DeFi machine. Unfortunately, these protocols will be stuck offering near zero rates — they were designed to provide yield with zero* risk, pricing interest rates based on supply and demand, without a design flexible enough to manage incremental risks and thus generate incremental yield. Many investors will seek higher yields to meet their investment return objectives.

This is where Goldfinch is different — by lending to real-world borrowers, the Goldfinch protocol is able to use any form of collateral to back its loans, instead of relying solely on digital assets as collateral. As a result, Goldfinch is able to deploy capital at scale by collateralizing real-world productive assets on-chain, resulting in sustainably higher yields.

As an added benefit, global demand for real-world credit is perhaps the largest financial market in the world.

How does it work?

The Goldfinch protocol was designed from the start to be able to form consensus around discreet underwriting decisions — the community is involved in underwriting each new loan that is made on the platform without requiring a governance vote like nearly every other lending protocol in DeFi.

Current governance systems in DeFi are relatively flat — a large portion of a community is required to vote and agree on every major decision. This works well for a change to the protocol mechanics, which is quite infrequent, but would quickly bog down if a vote from the entire community was required for every loan, when the goal at scale is to deploy hundreds or thousands of loans per month.

This is a next generation governance system, a form of “Trust through Consensus” — this system is ideal because it leaves collective wisdom and consensus in-tact, one of the greatest features of Web3, while creating attractive incentives for individual agents to make nimble decisions at scale.

The system has 4 primary participants:

1. Borrowers seek financing from the protocol.
2. Lead Backers bring borrowers seeking financing to the protocol and are responsible for managing the loan through its tenor. Lead backers get paid by earning a spread between the cost of funds offered by the protocol and the rate paid by the borrower.
3. Backers make up the junior tranche and supply first-loss capital for financing loans. Backers are responsible for evaluating the terms of a loan and creditworthiness of a Borrower. In a sense, the Backers collectively form consensus around whether a Borrower is creditworthy or not. When Backers evaluate risk correctly, they receive boosted returns because the senior tranche provides pools with additional capital and pays the Backers a portion of the interest it earns from the loan. If Backers are wrong about a Borrower and that Borrower defaults, then the Backers are first in line to lose money, which offers a cushion to the Liquidity Providers who are senior to the Backers and passive in the credit underwriting process.
4. Liquidity Providers provide capital to the senior pool, which in turn automatically funds the senior tranche of every loan that a sufficient number of Backers have decided to fund. Participation in this pool is permissionless and earns passive yield. Since Backers evaluate borrowers and provide first-loss capital, 20% of the senior pool’s nominal interest is redirected towards Backers.

How does this work in practice?

Suddenly, anyone around the world who has access to borrowers and the ability to underwrite credit can act as a Lead Backer and propose yield generating lending opportunities to the Goldfinch community of investors, who are also anywhere in the world.

The Goldfinch community of Backers vote with their money by investing in the junior tranche of loans offered on the platform by Lead Backers — taking a junior position in a loan implies that these individual Backers are willing to take a risky, first-loss exposure to the loans. In other words, if the loan doesn’t perform, junior Backers are first in line to lose their money before the senior pool does. If enough unique Backers vote with their wallet to take a junior position in a particular loan, then the larger Goldfinch senior pool will algorithmically fund the remaining principal of the loan.

This whole process happens in a matter of minutes after a review period that provides Backers a chance to review loan documents. Ultimately the protocol deposits cryptodollars (USDC) directly to the Borrower’s wallet, anywhere in the world.

Liquidity Providers who invest in the senior pool are essentially investing in an index of low-risk loans that have been approved by a community of independent loan underwriters. The incentive structure for Backers encourages them to generate the highest risk-adjusted yields possible- these higher yields flow through to the senior pool as well (net of the 20% fee to Backers), thus creating a direct channel for liquidity providers to access a nearly endless source of real-world yield that is both passive and completely liquid.

This system is the first of its kind in DeFi, a hybrid decentralized governance system that has both a discrete decision-making function for each loan (the underwriting process for Backers) and an automated governance-free decision-making process for deploying senior pool funds. These combine to create a system that is highly scalable in that it doesn’t require the entire community to agree on making an individual loan, and is also effective at making intelligent discrete lending decisions quickly for borrowers anywhere in the world — in other words, Goldfinch is the first Web3 protocol to bring human judgement on chain at scale.

The end state for the Goldfinch Lead Backers and broader Backer community is one where a highly sophisticated, experienced credit analyst — one who works (or once worked) at Goldman Sachs, Blackstone, or JP Morgan — decides to act as their own agent and start bringing loans to the Goldfinch platform as a Lead Backer to earn fees for completing, monitoring, and collecting loans. Fees earned by Lead Backers and yields earned by Backers on the platform were designed to be at parity, if not higher, that what is available to that participant in a similar circumstance in traditional finance. In the same way that Uber has allowed anyone who can drive to become an independent operator, Goldfinch will do the same for lending. As capital in the Goldfinch platform increases, the value proposition for those in traditional finance to begin acting as their own agents on Goldfinch will increase as well.

How big can Goldfinch get?

Goldfinch sits at the nexus of two powerful phenomena: the birth of DeFi, which is driving the emergence of a global capital market, and the creation of on-chain incentives that bring human judgement on-chain at scale. This has the potential to create an extremely powerful flywheel that will propel the protocol to deploy tens if not hundreds of billions of dollars in loans globally, which may lead to the protocol being valued at a similar order of magnitude.

Over the last decade examples of flywheel businesses rapidly disrupting traditional businesses have become somewhat common, and, as a result, better understood. Amazon provides a useful anecdote for both DeFi generally and Goldfinch specifically.

The scalability and network effects of the Amazon third party retail marketplace has enabled the company to capture an ever-increasing portion of e-commerce retail and total retail sales, proving that network effects can drive marketplaces to capture significant market share in massive and previously highly fragmented markets like U.S. retail.

We think Goldfinch has the potential to do the same for lending. Goldfinch’s flywheel resembles Amazon’s retail marketplace. On one side you have consumers looking for goods, comparable to Liquidity Providers and Backers, and on the other you have sellers of goods, comparable to the Lead Backers on Goldfinch.

Amazon has been able to capture significant share because of the powerful flywheel they have built — more consumers drive more sellers to the platform so they can sell more volume, and more sellers create more variety for consumers, creating a virtuous cycle.

Goldfinch is the same — more investors seeking yield increases capital in the senior pool, lowering interest rates, which brings more Lead Backers who have loans they are seeking funding for — more loans equals more diversification, driving down risk and thus bringing in more investors seeking yield, which decreases the cost of capital, increasing Goldfinch’s addressable market and bringing in more Lead Backers.

The Goldfinch flywheel is just getting started — as of January 2022 the protocol has deployed nearly $40 million in capital to 232,000 borrowers in 18 countries.

The potential for the Goldfinch protocol to meaningfully improve financial inclusion for the people and countries that need it most is perhaps the most significant practical impact of its success. Philosophically, Goldfinch is one of the first of many web3 platforms to come that will connect the digital world to the physical world and will provide truly equal access to the global economy for people with skills, in this case credit judgement. With the creation of the Goldfinch protocol, we are moving one step closer to the ideals of a global economy with equal opportunity for people who would otherwise have been limited by their location.

If you’re interested in getting involved, join the goldfinch community on Discord, Twitter, or participate directly in the protocol at app.goldfinch.finance.

Appendix: How much can the Goldfinch protocol be worth?

To provide a sense of the potential value of the protocol at scale, assume that the weighted average yield of loans originated by the platform at scale is 7%. Goldfinch’s take rate is 10% of interest earned on loans made by the platform. Taking these together, we can project what Goldfinch could be worth on a fully diluted market cap basis, based on the market share of Global Private Credit:

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