How does DeFi Lending Work?
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.
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.
Scheme of the algorithm of the decentralized credit protocol. Source
For the creditor, the process is as follows:
Main advantages of DeFi-lending. Source
Among the main advantages of DeFi-lendings are the following:
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.
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.
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.
Fiat gateway. This feature allows users to buy digital assets with fiat currency, making it much easier for those new to the cryptocurrency world to adapt to this market (and decentralized finance). In addition, the fiat gateway also makes it easier to integrate credit platforms with third-party services and applications outside the cryptocurrency industry.
Automation. In the DeFi sector, more of the routine business processes are automated and standardized through smart contracts. Therefore, investors in the DeFi lending business don't have to worry about their payments and/or dividends being frozen, stolen, or transferred to someone else by mistake. In addition, automation allows you to develop a mechanism for automatic payment of taxes and other mandatory fees and payments (if local laws require it).
DeFi-loans are already hugely popular because of their affordability, simplicity, and economic appeal to borrowers and lenders alike. Thanks to them, it is possible to earn interest income from deposits without having to deal with banks or any actual counterparties. Exchange traders can make quick loans, making stock markets and capital markets more efficient. Companies can combine long-term speculative positions with short-term leveraged liquidity.
In traditional finance, these are all separate markets, which are often quite inefficient because they have long chains of intermediaries and aggregators standing between lenders and borrowers. Decentralized lending can easily bypass this separation through capital pooling, which requires no intermediaries or regulators, as contract rules and mechanisms can be built into the code of automated and self-executing smart contracts.
All this makes DeFi-lending a very promising area of decentralized finance, especially for lenders, because anyone can become a lender now, regardless of location, size of starting capital, or other factors. The main thing is to have access to the Internet, a cryptocurrency account, and at least some cryptocurrency in this account - $10 is enough.