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What Is DeFi Lending?

Zainab Saberi

Aug 22, 2023 • 10 min read

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The ascent of decentralized finance since 2020 has been nothing short of meteoric. Dune Analytics has highlighted an impressive surge to approximately 4 million users interacting with DeFi platforms, notably DeFi lending, marking an expansion nearly 40-fold from 2020's numbers. Currently, data from DeFi Pulse indicates a sizable $40 billion in crypto assets being actively engaged— be it as loans, collateral, or liquidity pools. This is a noticeable decrease from the $175 billion figure observed in November 2021.

DeFi marks a groundbreaking shift in the lending landscape. Since the industrial age, conventional financial tools have utilized third-party intermediaries to sanction loans based on creditworthiness. Interestingly, even as the digital revolution reshaped various sectors, this fundamental aspect of borrowing didn’t undergo much change.

Also Read: What is Defi

Understanding DeFi lending and decentralized finance

In stark contrast, decentralized finance introduces an avenue where individuals have the autonomy to retain their assets while simultaneously accruing interest on them. Through the integration of blockchain-driven smart contracts, participants can actively choose their preferred money market, dictating where to lend and the corresponding interest rate based on the prevailing annual percentage reward (APR). On committing to a loan, the lender receives a fresh token, symbolizing the value of the original sum along with the accumulated interest.

One of the standout features of these lending reservoirs is their universality. They don’t rely on traditional metrics like credit ratings or socio-economic status. On paper, it seems more inclusive than its traditional counterparts, especially when considering the financial inclusivity it can bring to the underbanked. Moreover, while traditional lending models might involve tangible assets like a house as collateral, in DeFi, the only collateral is the tokens themselves.

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How Does DeFi lending Work?

For the decentralized lending mechanism to function seamlessly, two core elements are pivotal. Firstly, ensuring that each loan is distinct and non-exchangeable. This is where blockchain's innate quality of transaction permanence becomes crucial, facilitating the credibility of digital assets.

Each transaction within the blockchain is stamped with a timestamp and arranged in a chronological manner. Owing to cryptographic security and synchronization across a vast network of nodes, the possibility of tampering with any transaction is almost nil.

The second vital component is the smart contract. These are intricate software protocols integrated within the blockchain's blocks, and they dictate the rules for transactions.

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Here's a simplified step-by-step process of how decentralized lending operates:

1. Lenders deposit their digital currencies into a smart contract.

2. This contract acts as a reservoir, akin to a bank's vault, accumulating funds to form a liquidity pool.

3. Borrowers can then tap into this pool, adhering to terms defined by the smart contract.

4. These terms can encompass everything from the principal sum, interest rates, and collateral specifics, to thresholds for loan liquidation.

What sets DeFi lending apart is its dependency on digital collateral rather than conventional credit evaluations. If a borrower defaults, the smart contract autonomously actionizes the liquidation of the collateral, ensuring the lender retrieves its initial investment without resorting to traditional recovery methods.

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Example of DeFi Loans

A shining example in the realm of lending decentralized applications (dApps) within the Ethereum framework is Aave. The sleek interface that pops up when you tether your MetaMask wallet to Aave isn't just an interface—it's the dApp itself, the intuitive bridge to Ethereum's intricate smart contracts.

Suppose you're in the mood to acquire a stablecoin, specifically USDC, mirroring the dollar's value with a smooth conversion process. In the month of October 2022, from a vast liquidity reservoir amounting to $975M, an impressive sum of $446M was drawn from the USDC pool. Borrowers faced a constant APR of 10% while encountering a fluctuating APR of 1.82%.

Data Source: Aave

It's crucial to discern that annual percentage yield (APY) fundamentally represents compounded interest, setting it apart from APR. Lenders are often inclined towards APY figures, as this is what accrues from the borrower's deposit. Conversely, borrowers are charged an APR on their loans. To sidestep the unpredictable tremors of the market, most borrowers gravitate towards a fixed APR.

With the financial terrain becoming more bearish in 2022's latter half, choosing the constant APR didn't pan out well for many, as the fluctuating APR plummeted by a multiple of five. To get your hands on the USDC stablecoin, you're required to present a cryptocurrency as collateral. Aave proudly parades an extensive inventory of digital currencies that are eligible as collateral, each with its own corresponding APY rate.

Data Source: Aave

Your choice of collateral will dictate the liquidation threshold. As instance, employing ETH as your collateral means accepting an 86% liquidation threshold. If your loan's worth plunges below 86% of your collateral's value, automatic liquidation of the collateral is initiated. This underlines the wisdom of utilizing other stablecoins as security.

Also Read: What is Cryptocurrency

Types of DeFi lending/Loan

Collateralized Loans

Collateralized loans are bolstered by an asset serving as collateral. In the crypto domain, this collateral usually manifests as other cryptocurrency holdings valued higher than the actual loan. This strategy ensures that if the borrower falters, the lender can mitigate their losses by offloading the collateral. This collateral remains in the lender's custody until the loan is squared away.

Undercollaterized Loans

Achieving under-collateralization remains an ambitious target within the DeFi ecosystem. With over-collateralization, the borrower's financial reputation is secondary since the collateral is already secure. DeFi's hurdle is formulating ways to extend loans to individuals who lack substantial assets for over-collateralization.

DeFi enthusiasts aim to democratize lending while upholding decentralization principles. Solutions are emerging, with some harnessing blockchain technology to assess borrower trustworthiness, while others incorporate off-chain data or assets.

Overcollaterized Loans

In the TradFi sector, lenders often mandate collateral for loan security. Consider home mortgages—the property acts as the collateral, which the lender can claim in case of defaults. This setup is known as a secured loan. On the other end of the spectrum, unsecured loans like credit card debts don't demand collateral, leading to steeper interest rates due to the heightened risk.

In the DeFi realm, borrowers are obligated to deposit cryptocurrency collateral—usually tokens valued considerably higher than the loan, often ranging from 1.5 to 3 times the loan's value. This collateral is under the safekeeping of the loan's governing smart contract until full repayment. Over-collateralization is often favored by individuals with significant crypto assets.

So, what motivates one to lock in a larger crypto amount for a smaller loan? Some aim to sidestep capital gains taxes on their holdings. Others anticipate their crypto assets to appreciate over time. By using them as collateral, they can access funds for immediate use, hoping to retrieve their collateral later at a higher value. Some strategically borrow to leverage various trading stances.

A distinct advantage of DeFi loans is the absence of borrowing time constraints. The loan remains active as long as the collateral value remains above the borrowed sum. Yet, if the collateral's value dips dangerously low, the loan's smart contract autonomously initiates collateral liquidation.

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Uncollateralized loans

A scenario where the borrower provides no collateral. Borrowing limits are determined by the pool's stipulated maximum, usually accessible to affluent individuals and entities.

Flash loans

Flash loans are innovative solutions to the under-collateralization conundrum. They demand substantial expertise and diverge from conventional loans in terms of duration—flash loans last mere seconds to minutes. If repayment isn't completed within the allotted timeframe, the loan is nullified by the smart contract, rewinding to the pre-loan state. Typical uses for flash loans include:

Swift collateral and interest rate exchanges. A borrower identifies a platform with superior loan conditions, secures a flash loan, repays the original loan, and initiates a new one with better terms.

Arbitrage strategies, where a loan is utilized to purchase crypto on one exchange, subsequently sold at a premium on a different platform. After settling the loan and interest, the borrower retains the profit.

Despite their allure, flash loans remain a niche due to the expertise they demand. Their susceptibility to cyber threats also raises concerns. Broader acceptance of under-collateralized loans in DeFi hinges on the evolution and maturity of alternative lending methods."

Pros of DeFi lending

Speedy Loan Processing

Digital lending methods, especially in the DeFi realm, harness the power of cloud technology, fraud detection analytics, and machine learning to determine the best loan conditions and assess risk. This powerful amalgamation drastically reduces the time taken for loan approvals. Once approved, e-contracts convey the lender's proposals swiftly.

Uniformity in Loan Determinations

Clear and defined credit policies ensure that lending choices remain consistent. This framework prevents inconsistency in assessing applicant qualifications or in deal structuring by the underwriters.

Adherence to Regulatory Standards

Decisive protocols provide traceable data, showcasing where, when, and which regulations were applied. This becomes crucial evidence that confirms adherence to local, state, and federal legal standards.

Insightful Analytics for Enhanced Processes

Analytical tools aid both borrowers and lenders in making the most of their digital lending journey. Regular monitoring of loan requests helps forecast demands and thus optimize resource allocation. Analytics sheds light on various parameters like borrower demographics, credit categories, and loan origination sources. These insights pave the way for improved portfolio performance.

Unrestricted Access

DeFi lending is characterized by its open, unrestricted access. Any individual possessing a crypto wallet can tap into DeFi platforms operating on Blockchain, irrespective of their geographic location or the amount of funds they hold.

Unparalleled Transparency

Every transaction on the public Blockchain is openly broadcasted and validated by the entire network's user base. Such an unparalleled degree of transparency around transactions facilitates comprehensive data scrutiny and guarantees every network user authenticated access.

Inalterable Nature

Blockchain’s decentralized blueprint ensures that data remains invulnerable to alterations, bolstering its security and audit trail.

High Customizability

Smart contracts are versatile, facilitating automated operations and fostering the invention of new financial tools and digital assets.

Seamless Integration

The collaborative nature of the software platforms ensures that DeFi applications and protocols work in harmony, enhancing each other's functionalities.

Direct Asset Control

With tools like Web3 wallets (e.g., Metamask), DeFi participants maintain direct control over their assets and data.

Cons of DeFi lending

For those looking to venture into DeFi lending, it's crucial to understand the risks that accompany this domain.

Potential for DeFi Rug Pulls

DeFi's landscape, being relatively unregulated, poses the challenge of trust. There have been instances where DeFi developers introduce a token, amass investments, and then unexpectedly abandon the initiative – a phenomenon termed 'rug pull'.

Threat of Flash Loan Attacks

Exclusive to DeFi, flash loans are uncollateralized loans. Owing to the multiple transaction capability of blockchains, users can borrow cryptocurrency, conduct transfers, interact with smart contracts, and conclude by repaying the borrowed amount, all within the same transaction. In instances where repayment isn't met, the transaction can be reversed. Given its decentralized nature, anyone can access a DeFi flash loan, devoid of any creditworthiness checks.

Is DeFi lending Safe?

Navigating the landscape of DeFi lending in DeFi poses its unique set of challenges. One primary concern is the swift fluctuations in interest rates. APYs are not constant, fluctuating based on lending and borrowing dynamics within specific money markets. Unmonitored interest rates might skyrocket, potentially leading to the liquidation of your assets. It's not uncommon for DeFi platforms to witness liquidation peaks when there are sudden APY changes.

Furthermore, the onus is on users to be thoroughly familiar with the lending landscape. A basic oversight can result in substantial financial losses. It's imperative for participants to stay informed about the effects of over-collateralizing tokens on the coin markets they're exploring.

The advantages of DeFi stem from its integration with blockchain technology and smart contracts, which translates to reduced transaction costs, increased transparency, and enhanced security through decentralized records. Yet, being rooted in open-source blockchain technology, it isn't impervious to hacking threats.

How to lend in DeFi?

For those aspiring to lend their digital assets on a DeFi lending platform, there are three essentials:

- Digital wallet

- Cryptocurrency

- Lending platform site

Digital wallet: Also known as crypto or web3 wallets, they serve as repositories for cryptocurrencies and varied digital commodities. Optimal wallets operate on a self-custodial model, exemplified by Metamask Wallet. With self-custody, you wield full authority over the wallet's content, contrasting with custodial wallets where a third entity maintains control. Delve deeper into the significance of self-custody here.

Cryptocurrency: Your wallet must house a cryptocurrency, which caters to transaction charges and potential swaps. Transaction costs are levied for blockchain modifications and are settled using the blockchain's inherent gas currency. For instance, ETH addresses transaction fees within the Ethereum blockchain. To initiate lending, your wallet should encompass a cryptocurrency approved by the lending platform. Navigate through these articles to gain insights on purchasing or exchanging cryptoassets.

Lending platform site: Prioritize lending platforms that have a track record of trustworthiness, support a diverse range of esteemed crypto assets, and offer competitive returns. The subsequent segment discusses a platform that meets these criteria.

DeFi Lending: The Future of Finance?

DeFi lending is revolutionizing financial accessibility. Possessors of non-custodial wallets can seamlessly connect with a lending dApp on an unrestricted public blockchain, necessitating only collateral via their wallet.

Simultaneously, individuals have the liberty to morph into lenders, virtually establishing their decentralized mini-banks. However, it's crucial to remain vigilant against potential vulnerabilities in smart contracts, commonly seen in flash loans, which can deplete liquidity reserves and jeopardize the entire system.

Still, the ascent of DeFi lending is undeniable. Its emergence as a versatile and resilient counterpart to conventional banking is evident. Minor setbacks within its nascent years since its inception should be perceived as growth-teething problems.

Also Read: How to Stake ETH

FAQs

Q: Is DeFi lending Safe?

A: DeFi lending, like other financial avenues, carries inherent risks. While platforms incorporate security measures, it's crucial for users to research and choose reputable platforms and understand the terms before participating.

Q: How Do You Make Money Lending Crypto?

A: By lending cryptocurrency on certain platforms, you can earn interest. Rates can vary depending on the platform, the type of cryptocurrency, and market demand. Lenders typically earn money as borrowers pay back the loan with added interest.

Q: Is DeFi lending a good idea?

A: DeFi lending can be advantageous for those looking to earn passive income on their crypto assets. However, it's essential to weigh the potential rewards against the risks. Always research and understand the platform's terms and potential market volatility before lending.

Q: What are the cons of DeFi lending?

A: Some cons include potential default by borrowers, platform insolvency, market volatility affecting the value of lent assets, and potential security breaches. Moreover, with evolving regulatory frameworks, there can be unexpected legal implications.

Q: Which are good DeFi lending Platforms?

A: Several platforms are reputable in the DeFi lending space - Aave, Binance, Yearn Finance, dydx, AQRU to name a few. However, it's essential to conduct due diligence, read reviews, and understand their terms and conditions before using them.