How does Defi Lending Work?
As organizations started experimenting with Blockchain’s potential, the financial sector has also presented the need to build blockchain-based fintech applications. By covering almost all the financial services from online payments to cryptocurrency trading and storage, Blockchain is set to transform the traditional finance system. With the emergence of Defi (Decentralized Finance), Blockchain has grown to be even stronger.
With lots of excitement generated already in the market, Defi has kept powering ahead and attracted an impressive capital amount since 2020. According to Defi-Pulse, the Total Value Locked (TVL) in Defi protocols is at $20.46 billion today, up from less than $1 billion a year ago. The focus point here is that Defi has grown more than twenty folds in a year, clearly indicating the amount of popularity Defi has surged.
Defi lending has found its status quo. The leaders (Maker, Compound and Aave) have solidified themselves as the users’ priority choice to lend and borrow Defi tokens. The three biggest lenders for Defi are Maker, Aave and Compound, with a total value of $4.25 billion, $2.82 billion and $2.64 billion, respectively.
Let’s understand what makes Defi and Defi lending such a popular hit. The article discusses each of the following points in detail:
- What is Defi?
- What is Defi lending?
- Defi Lending vs. Traditional Lending
- How do Defi loans work?
- What are the benefits that Defi Lending provides to its users?
- How do Defi Lending platforms help the financial services sector?
- What are the popular Defi lending and borrowing platforms/ protocols?
What is Defi?
In most simple terms, decentralized finance is an ecosystem of financial applications based on Blockchain technology that operates without any third-party or central administration intervention. It uses a P2P network to establish decentralized applications that would enable everyone to connect and manage their assets regardless of their status and location. It aims to provide an open-source, transparent and permissionless financial service environment.
Smart contracts are the foundation layer for decentralized finance as they are self-executing and do not require intermediary oversight. Since Ethereum introduced the Defi concept, most of the Defi applications are built on Ethereum Blockchain.
What is Defi lending?
Defi lending platforms aim to offer crypto loans in a trustless manner, i.e., without intermediaries and allow users to enlist their crypto coins on the platform for lending purposes. A borrower can directly take a loan through the decentralized platform known as P2P lending. Besides, the lending protocol allows the lender to earn interests. Among all of the decentralized applications (DApps), Defi has the highest lending growth rate and is the most prevalent contributor for locking crypto assets.
Defi Lending vs. Traditional Lending
The underlying technology for defi lending is Blockchain; Defi utilizes all its unique features and performs exceptionally well compared to traditional lending. Defi lending offers complete transparency with easier access to assets for every money transfer process without involving any third-party. It provides the most straightforward borrowing process; the borrower needs to create an account on the Defi platform, have a crypto wallet and open Smart contracts. Defi offers a censorship-free environment, meaning there is no preferential treatment while ensuring immutability.
Defi lending benefits both lenders and borrowers. It offers margin trading options, allows long-term investors to lend assets and earn higher interest rates. It will also enable users to access fiat currency credit to borrow loans at lower rates than decentralized exchanges. Moreover, the users can sell it on a centralized exchange for a cryptocurrency and then finally lend it to decentralized exchanges.
How do Defi loans work?
The underlying value of crypto assets may increase or decrease, but sitting idle in wallets doesn’t accrue any interest. Just holding a particular cryptocurrency won’t make any earning. It is the situation where Defi loans come into the picture. Defi loans enable users to lend their crypto to someone else and earn interest on the loan. Banks always have been utilizing this service to the fullest. Now, in the world of Defi, anyone can become a lender. A lender can loan their assets to others and will be able to generate interests on that loan. This process can be done through lending pools, the loan offices of traditional banks.
Users can pool their assets and distribute them to borrowers using smart contracts. There are various ways to distribute interests to investors; hence it is recommended and worth investing some time to research to identify your interest type. The same goes for borrowers, as each pool will have a different approach on how to borrow.
While taking a loan from a bank, collateral is required that is associated with that loan. For example, for a car loan, the car itself is collateral. When the user stops paying the loan, the bank will seize the vehicle. The same goes with the decentralized system; only the difference is that the system is anonymous and doesn’t involve any physical property used as collateral. To get a loan, the borrower needs to offer something more valuable than the loan amount. Smart contracts are used to deposit this amount of currency of at least equal value to the loan amount. Collaterals are available in wide varieties; any crypto token can be used to exchange borrowed cryptocurrency. For example, if a user needs to borrow one bitcoin, he’d need to deposit the price of one bitcoin in DAI.
Furthermore, the prices of Bitcoins keep swinging wildly. A case may arise when the cost of collateral drops below the price of the loan. Now, here the question arises, How to deal with this situation? An example could explain it better. Let’s say a user wants to borrow 100 DAI. MakerDAO requires borrowers to collateralize their loans at a minimum of 150% of the loan value. This straight away means that the borrower needs to collateralize the loan with $150 in ETH. And when the value of collateral reduces below $150 ETH, it becomes subject to liquidation penalty.
What are the benefits that Defi Lending provides to its users?
- Improved loan origination speed
Digitally-enabled lending processes have the most significant advantage of fast processing speed. Defi lending platforms are backed by cloud-based services, analytics for fraud identification and detection and machine learning calculations for optimum loan terms and risk factors. All these technologies eventually help to speed up the process. As soon as the loan is approved, lenders send offers via e-contracts.
- Greater consistency in lending decisions
Rules describing credit policies guarantee consistency in lending decisions. Variations in evaluating applicant attributes and structuring deals by underwriters are eliminated.
- Compliance with Federal, State and Local regulations
Decision rules provide a record of who, when and where the rules were used and which rules were in effect. It plays the role of evidence and ensures that the lender complies with federal, state and local regulations.
- Analytics for process improvement and portfolio profitability
Analytics can help lenders and borrowers get the most out of the digital lending process. Monitoring loan applications over a particular duration (a week, month or year) can help lenders anticipate and allocate proper resources to accommodate seasonal demands. Analytics also provides insights into demographics, loan sources, credit tiers, etc. The portfolio can be improved by determining how borrower characteristics and credit policies affect loan performance.
Defi lending allows open, permissionless access, meaning anyone with a crypto wallet can access Defi applications built on Blockchain, regardless of their geographical location and without any minimum amount of funds required.
The public Blockchain broadcasts every transaction on the network and is verified by every user on the network. This transparency level around transactions allows for rich data analysis and ensures verified access to every user on the network.
Blockchain’s decentralized architecture ensures tamper-proof data co-ordination and increases security and auditability.
Smart contracts are highly programmable, automate execution and enable the development of new digital assets and financial instruments.
The use of an interconnected software stack ensures that Defi protocols and applications integrate and complement one another.
The use of Web3 wallets (like Metamask) ensures that Defi market participants keep strong custody of their assets and control their data.
How do Defi lending platforms help the financial services sector?
- Lending and Borrowing
The most widely used Defi lending applications involve peer-to-peer lending and borrowing protocols. Aave, Compound and Maker are a few of the most popular Defi platforms.
Defi lending platforms have come up with numerous innovative ways for people to manage their savings. By plugging into different lending platforms, users can avail themselves of the services of interest-bearing accounts and maximize their earnings. Interest-bearing accounts can help the user to increase their profits when compared to traditional savings account exponentially. The most popular savings dApps include Argent, Dharma and PoolTogether.
- Asset Management
Defi lending protocols and crypto wallets like Gnosis Safe, Metamask and Argent enable users to be custodians of their crypto assets. It allows users to quickly and securely interact with the decentralized apps and avail the services of buying, selling, transferring crypto and earning interest on investments.
What are the popular Defi lending and borrowing platforms/ protocols?
Maker is a unique Defi crypto lending platform that allows borrowing only DAI tokens. DAI is a stable coin whose value is pegged to US dollars. Anyone can use the Maker to open a vault, lock in collateral like ETH or BAT, and generate DAI as a debt against that collateral. It encourages users to participate in operational earnings through governance fees, which act as interest rates for the network. DAI can be borrowed up to 66% of the user’s collateral value. If the vault falls below the fixed-rate, it becomes subject to a 13% penalty and liquidation to bring the vault out of default. At a 3% discount, liquidated collateral is sold in an open market.
Maker’s other token is MKR; holders of MKR act as the last line of defense in case of a black swan event. If the collateral value starts to fall, MKR is minted and sold in an open market to raise more collateral, diluting MKR holders.
Maker’s Oasis Portal is the most popular place to use MakerDAO, allowing opening, managing, and reviewing vaults, deposit DAI into DSR (DAI Savings Rate) and getting updated stats on the entire Maker system.
It is an open-source and one of the most popular Defi lending protocols launched in 2020. It is a non-custodial liquidity protocol for earning interests on deposit and borrowing assets. This platform allows lenders to deposit cryptocurrencies in a pool and receive an equivalent amount of aTokens (comparable to cTokens of the Compound protocol). Aave algorithmically adjusts interest rates depending on demand and supply. It indicates that the more the user holds aTokens, the better the interest amount.
It is an algorithmic and autonomous money market protocol intended to unlock a universe of open financial applications. It allows users to deposit cryptocurrencies, earn interests and borrow other crypto assets against them. The use of Smart contracts automates the management and storage of capital on the platform. Web 3.0 wallets such as Metamask allows users to connect to Compound and earn interest. It is a permissionless protocol meaning anyone with a crypto wallet and an internet connection can freely interact.
Recently, in 2020, Compound launched its governance token ‘COMP.’ It provides voting rights to token holders over things like the decision to incorporate new assets, protocol upgrades or technical upgrades on the platform.
Compound’s native tokens, called cTokens, are used to track positions (supplied assets) in Compound. These tokens are ERC-20 tokens (Ethereum Request for Comments) that display claims to a portion of an asset pool in Compound. For instance, when a user deposits ETH into Compound, it is converted into cETH; likewise, if a stable coin DAI is deposited, it is converted to cDAI. In multiple coin deposition cases, they will each earn interests based on their interest rates. It means cETH will earn a cETH interest rate and cDAI will earn a cDAI interest rate.
Compound finance supports various lending and borrowing assets, including DAI, ETH, WBTC (Wrapped Bitcoins), REP, BAT, USDC, USDT and ZRX.
This detailed discussion shows that Defi lending has a high potential to reshape the entire financial system. It attempts to decentralize the core traditional finance services like payments, trading, investments, insurance, lending and borrowing. Defi lending being involved with the intriguing technology truly has vast opportunities to revolutionize the global financial landscape.
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