The money market, i.e., the concept of borrowing and lending of any form — mortgages, student loans, etc. — is one of the fundamental tenets of the financial system.
Lenders provide funds to borrowers while expecting that the borrower repays the borrowed amount with interest.
Traditionally, financial institutions like banks or peer-to-peer lenders facilitate the process of connecting borrowers and lenders control access as well as borrowing/lending rates.
Decentralized finance (DeFi) is another approach to serving the large underserved population of crypto investors and traders. DeFi offers an open protocol to allow anyone in the world to issue, lend and borrow crypto assets, as well as provide services like insurance and interest payments.
In contrast to CeFi, which is centralized and is currently more popular. They then lend out the deposited assets to other parties, often institutional actors such as market makers, hedge funds, and so on.
In contrast, DeFi lending offers innovation in access, efficiency, and transparency, allowing users to borrow and lend without providing personal information, proving identity, or undergoing “know your customer” (KYC). So, what exactly is DeFi lending, and how does it work?
DeFi Lending and How It Works
Cryptocurrencies sitting in wallets do not earn interest. Their underlying values may increase or decrease, but users will not earn by just holding that particular asset. That’s where DeFi lending comes into play.
Imagine lending your cryptocurrency to someone else and earning interest on the loan. That is how banks currently operate, but it is a service that few people can access. However, in the DeFi space, anyone can become a lender.
You can generate interest on your crypto assets by lending them to others. There are several ways to accomplish this, but the most common is through lending platforms/protocols.
How DeFi Lending Works
Lenders not only earn interests on their deposited assets but also receive a governance token as an additional incentive — Maker issues DAI, Aave generates LEND, and Compound rewards COMP.
The platforms use these tokens to calculate accrued interest, and users need them to redeem their funds.
Also, lending rates, for the most part, adjust with each Ethereum block. Price oracles determine ideal annual percentage yields (APYs), which fluctuate to ensure the protocol runs safely.
How DeFi Borrowing Works
DeFi lending protocols use smart contracts to distribute pooled assets to borrowers with the loan terms written into the contract.
Also, DeFi protocols require no permission to use. Hence, its services can’t rely on traditional evaluations such as credit score, income, or equity to determine safe loan amounts.
DeFi loans are always over-collateralized. That means that borrowers can only receive a fraction of the collateral they put up. So, if you put up $10,000 in ETH, you can get up to $7,500 in DAI or other assets (representing 75% of your collateral).
Although this may seem counterintuitive, it is crucial to ensure that every borrower can repay their loan. If you cannot repay your borrowed amount, your collateralized assets may be liquidated.
What Makes DeFi Lending Stand Out from Traditional Lending
Traditional lenders always charge astronomic interest rates. But, there’s a reason for that. Large financial institutions within the private sector are profit-driven, resulting in higher interest rates. The revenues earned from loans are distributed to board members and stockholders.
However, DeFi protocols are not actual entities or institutions with board members and stockholders.
Instead, there are token holders (for example, MKR token for Maker DAO). The fees earned on loan repayments benefit the token holders, who form a decentralized community.
By exchanging DAI for MKR, anyone may become a token holder on the platform. Token holders are similar to board members since tokens grant voting rights in determining the protocol’s policies and development.
The motive for owning MKR is as a type of reward. Unlike banks, which have a small group of executive board members that dictate policy, MKR holders represent a vast community that engages in digital governance.
Decentralized digital democracy is a way to make decisions in a group. A majority vote is used to make decisions in a bigger group. Banks make decisions based on a few individuals.
No paperwork or personal details are required in DeFi. However, to secure a loan using a DeFi protocol, collateral is required. A borrower must hold a digital asset like BTC or ETH to lock into a smart contract.
Over-collateralization begs the question, “Why would you borrow against your assets for a loan that is worth less than your collateral?” That is simply because many cryptocurrency holders do not want to sell their most valuable assets. They can unlock liquidity without trading by lending their funds.
For example, if a person has $50,000 in ETH but isn’t willing to sell it, they can provide it to a lending protocol and borrow up to 75% of its value.
This also ensures lenders of the security of their funds as borrowed funds can be recovered if the borrower defaults on repayment.
The Future of DeFi Lending: Will It Topple Its Traditional Counterpart?
Despite DeFi lending’s potential innovations, it still has a long way to go before it could topple traditional lending. Furthermore, there are a couple of risks that accompany it.
Protocol’s public codes are susceptible to hackers seeking to exploit bugs and profit from malpractice attacks.
Users may also be vulnerable to more volatile fluctuations in APY. For example, during the 2020 DeFi craze, several borrowers were caught off guard by huge spikes as some cryptocurrencies rose 40%.
In addition, users must exercise extreme caution when dealing with wallets and addresses, etc. Bitcoin transactions are irreversible, which is unlike the traditional banking systems that can reverse transactions. The possibility of losing your private key and sending it to an incorrect wallet means that those funds are lost forever.
As DeFi evolves, we’ll see decentralized systems attempt to build services as functional as their brick-and-mortar counterparts. After all, these services are accessible to anybody with an internet connection, which means that anyone may buy and lend cryptocurrency.
However, like with everything crypto-related, it may be somewhat of a roller coaster, so do your research before determining whether DeFi lending is good for you.
If you like this article, try reading our article “Company Tokenization: Will The Stock Market Be a Thing of The Past?”