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02 March 2023

How does DeFi Lending Work?

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Let's describe how DeFi-lending works. We'll talk about its advantages and disadvantages, as well as give examples of platforms where you can take DeFi-lending.

According to DeFi Pulse and Defistation, DeFi lending/borrowing protocols such as Aave, Maker, Venus, and Alpaca Finance lead among projects by total blocked funds (TVL), indicating an unusually high demand for such solutions. Next, we'll tell you how DeFi lending works and why it has become so popular.

What is DeFi Lending?

In the world of traditional finance, lending and borrowing work as follows: people and organizations that have free funds lend them to other people or organizations for a period of time in exchange for a predetermined percentage of the borrowed funds. This usually involves intermediaries in the form of a bank or credit broker, who are responsible for checking on the borrower, drawing up the loan agreement, and monitoring its implementation. Of course, banks and brokers also take a fee in the form of a percentage for their services.

Devi-lending, as the name implies, is a decentralized version of such relationships, in which people and organizations can grant credits to other people and organizations without the involvement of third parties: banks and brokers. Their role is assumed by smart contracts - automated and self-executing algorithms in which all obligations of both parties and terms of lending contracts are coded, as well as the payment of percentages to creditors.

By removing intermediaries from the lending process, DeFi makes the transaction easier and the lending itself cheaper. But this comes at a price: the increased risk for the creditor of losing his money by giving it to a borrower who is unwilling or unable to pay it back. This problem is usually solved by the borrower providing excessive insurance.

Let's figure out what that means in DeFi-lending and how it works.

How DeFi-lending works?

Scheme of the algorithm of the decentralized credit protocol. Source

The principle of lending platforms is simple: first, the protocol collects users' funds into "money markets," and then uses them to issue loans to other users via smart contracts. Money markets are the same liquidity pools of cryptocurrency exchanges, only on lending platforms they are not needed to buy and sell cryptocurrency assets, but to provide loans of money.

For the creditor, the process is as follows:

  1. The customer chooses the credit DeFi-platform.

  2. The user then locks their assets into a smart contract on that platform, after which they become available for borrowing.

  3. When someone takes out lending denominated in these assets, the smart contract issues so-called "percentage tokens" to the lender, for example, in Aave these tokens are called aTokens, while in Maker they are called Dai.

  4. Percentage tokens the user can exchange for bitcoins, ether, or another crypto at any time and withdraw or reinvest them.

  5. Funds locked in a smart contract (money market) can usually also be withdrawn at any time.

For the borrower, the process is as follows:

  1. The user chooses a credit DeFi-platform.

  2. The user then needs to pay a pledge, which is usually larger than the loan itself, for example, on the Compound platform, the minimum pledge is 133%. Excess collateral is needed to protect against the ultra-high volatility of the cryptocurrency markets, that is, to have time to sell the collateral before its value falls below the actual value of the lending itself.

  3. When a pledge is locked in a smart contract, the borrower receives funds denominated in the cryptocurrency or fiat money they want.

  4. If the value of the pledge falls (concerning the value of the loan) before repayment, the borrower must increase it. If it does not happen, the pledge is usually put up for public auction.

  5. At the end of the lending term, the borrower must repay it. If this does not happen, and in this case, the pledge is put up for auction.

And while on paper it may seem absurd, since a user can simply sell their cryptocurrency assets and get the amount of money they need, there are many reasons why DeFi-borrowing makes sense:

Pros and cons of DeFi-lending

Main advantages of  DeFi-lending. Source

Now as we know how DeFi lending works, we can move on to look at the advantages and disadvantages of these types of lending platforms.

Among the main advantages of DeFi-lendings are the following:

In addition to the above advantages, DeFi-loans have significant disadvantages that you also need to be aware of. Here are the main ones:

DeFi- vs traditional lending

Decentralized lending emerged as an alternative to traditional banks, credit brokers, and private lenders. The main difference between them is the absence of centralized authorities and a much smaller number of intermediaries (there are almost none in DeFi). But this is not the only difference.

Here's a more detailed comparison of DeFi- and traditional lending:

As you can see from the table, DeFi-lending is very different from traditional practices. First, anyone can take a loan on DeFi-platform if he/she has the right amount of cryptocurrencies for pledging. Whereas on centralized platforms, the decision to lend depends on a moderator. Secondly, DeFi-platforms do not have access to users' money, they are responsible for its storage themselves.

How safe is DeFi-lending?

DeFi lending is quite secure because users do not store their funds on the platform, and all transactions are done via open-source smart contracts. Thus, DeFi's lending and borrowing process has become transparent and secure. Although, only to the extent that the smart contracts themselves are transparent and secure. That's why code testing by an independent audit is standard for all DeFi projects.

The possibilities of DeFi-lending protocols

DeFi-lending services have similar functionality to conventional lending platforms, but they also often have some unique features due to the decentralized nature of the product. Here's a brief description of those features.

External wallet. To take advantage of DeFi-platforms, users need to connect their crypto-wallet like defi, which will be responsible for storing the user's money. For example, Compound provides integration with crypto wallets Metamask, Ledger, Wallet Connect, Coinbase Wallet. Service Aave provides more opportunities - now there are 30 cryptocurrencies available.

Instant loans. This type of collateral-free lending has gained popularity in DeFi thanks to the Aave and dYdX lending platforms. They were the first to introduce the ability to take out instant unsecured loans in cryptocurrency. These loans issue smart contracts for a limited term, often with restrictions (no selling or transferring coins until the loan is repaid), and they are automatically canceled if the user cannot repay the loan.

Although term loans are a rather innovative and controversial concept, users have already appreciated their advantages. The ability to get a collateral-free credit almost instantly provides traders with more options to make money on newsworthiness, price discrepancies on different exchanges, etc.

Investment rewards. To motivate users to lend their funds to a lending platform to lend to other users, such platforms provide all investors with remuneration in the form of a percentage of funds invested. And this interest is usually two-three times higher than the interest on deposits in the United States, Canada, the United Kingdom, and EU countries. At the same time, the risks are lower than when investing in bank deposits in developing countries.

Shift speed. Fast rate switching allows borrowers to switch between stable and variable interest rates and thus protect themselves from sudden fluctuations in cryptocurrency markets, which are still very volatile. An example of the implementation of this custom option can be seen on the Aave credit DeFi-platform.
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