Borrowing and Lending in Decentralized Finance – DeFI

Disclaimer: User Generated Content – Original Content created by a member…

9 May 2022 | 8 min read

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Disclaimer: User Generated Content – Original Content created by a member of CoinDCX Ambassador Program – The Pathbreaker Initiative. The views and opinions expressed within this post belong solely to the author.

Article Source: What is Borrowing and Lending in DeFI?

Author: Raghav Dudeja

The crypto ecosystem has seen massive adoption in the past couple of years. The interesting factor that makes the new asset space so easy to explore is its decentralized nature! There is no third party involved when you are exploring the space and conducting your own research to find out which token you like best!

Decentralized Finance is a burgeoning niche in the crypto industry. Within a short span of 12 months, the industry size grew from $20B locked in value to $250B. This validates the hypothesis that crypto is here to stay. Not only that, but it also proves that Decentralized Finance is going to play an important role in crypto adoption. Decentralized finance has a lot of use cases that have the capability of transforming our traditional finance. However, in this post, we are going to talk about borrowing and lending in DeFi.

Borrowing and lending are the backbones of any thriving economy. It is a pillar used by governments to control prices and inflation. For instance, if a government wants to control inflation, they make it expensive to borrow money. Similarly, if they want to add fuel to the economy, interest rates are made cheaper. This means more people would borrow and spend. Thus, driving up the prices.

Additional Read: How will DeFi reshape the future of Finance – By Neeraj Khandewal, Co-Founder, CoinDCX

Why Decentralized (DeFi) Borrowing and Lending?

At this point, you may ask, why do we need to have decentralized borrowing and lending? What are the issues with the current banking system? And it is indeed a legit question. The banks across the globe have done a decent job in managing this portfolio for all of us. Then why is there is sudden urge to do away with them now?

Let us explore some legit reasons behind exploring DeFi avenues:

A. Unequal Access:

While banks try their best to lend money to most of the people that knock on their doors, they often have to comply with certain norms and regulations to ensure that their loan books are not filled with defaulters. Essentially, banks are in the business of loaning out your money at a certain percentage. However, if more and more people fail to give back that money, it is detrimental to their cause.

This means not all of us can have access to the same amount of loans. As you all might know that there is a credit score assigned to each individual. That score decides if or not we should be lent money and at what interest rates. This clearly creates a divide in the market where the rich keeps on getting richer and vice-versa. It takes a while for someone from middle class to build assets.

Also Read: What are DeFi Loans?

B. Access Restriction:

Let us take this up by talking about a recent situation in Ukraine. A lot of individuals fled to nearby countries like Poland to safeguard themselves. These innocent citizens cannot access their banks back at home. On top of it, these citizens cannot open bank accounts in the new country. Even if they do, it is going to be a long road before someone is willing to lend them money.

Therefore, there is a clear lack of access to lending services for these people despite having money and credit history.

C. Trust-Based Relationship:

We trust banks completely to keep our money safe and give it back to us if need be. This equation works well in an ideal world but the real world scenarios are quite different.

This trust makes banks an extremely powerful entity that gives rise to frauds if not handled carefully. For example, Indian business tycoon Nirav Modi bribed certain employees in one of the Indian banks to access collateral-free loans. Later, he defaulted on these loans, and who took the brunt? Yes, it is the unknowing taxpayers of the country.

This means while trust is an extremely important element of this relationship, more often than not, it is compromised.

D. Expenses:

To process these transactions related to borrowing and lending, banks also charge their customers a fee. This is obviously on the top of the interest rates they are going to levy. Nonetheless, who decides on this fee? Banks take a note of their customer satisfaction scores, add some value to ease out the process, and finally come up with this fee themselves.

But do you think it is fair? Even if there is a fee involved, the prices should be governed by the community. This would ensure that banks do not play the role of an opportunist.

E. KYC and Other Processes:

When was the last time you took a loan from the bank? Depending on the type of the loan, it could take anywhere between 10 days to a month. There is an elaborate process that can take forever for you to get the money in the bank.

Therefore, you can question the efficacy of the process.

F. Banks have the Final Authority

Banks conduct thorough due diligence before lending you the money. And it is absolutely fine to do so. But banks have standardized this process over the years. This means if you are planning to do anything unconventional, it would be difficult for the banks to fund your business.

For example, if you are building a crypto startup in a country where regulations around crypto are not clear, most of the banks will not fund your business.

G. Unbanked:

Globally, 1.3bn people do not have the access to the banks. However, about 60% of these people have access to a smartphone and the internet. The question here is that these people do not have access to capital because they are not registered with a bank.

Also Read: What is Crypto Lending?

What is Borrowing and Lending in DeFi?

Now that we have established the need for DeFi in borrowing and lending. Let us understand what it is and how it works. These basic banking functions happen via protocols like Compound and Aave. Maintaining the ethos of the Blockchain, these protocols are completely decentralized in nature. By eliminating the middle man, one can surpass the following problems:

Banking the unbanked
Accessible to everyone with collateral
No KYC required
Cheap (no middleman involved)
Trustless

How does Borrowing and Lending in DeFi Work?

Lending and borrowing in fact a huge part of our current financial system. Why this works seamlessly is because banks usually ask you to put something like collateral on the line. If you default on your loan, banks liquidate that collateral to recoup the money. There could be other legal consequences involved too if you fail to pay back. All this is possible because there is a whole set of documents and KYC involved before disbursing the loan.

How do you deal with the problem of defaulters in cryptoverse? There is no KYC. Anyone could make a small down payment and run away with the loaned amount.

The answer lies in over-collateralization and smart contracts. For borrowing fiat money worth $1000 you may have to put $1200 worth of cryptocurrency as collateral. One may ask why would I borrow if I already have the money? Well, say you hold BTC worth $1000 and you strongly believe that it is going to jump higher in the coming days. In such a case, you would not sell your holdings and instead borrow money using that crypto. You can use that money to trade elsewhere and make some money, only to come back and repay your loan.

But How?

Well, once again, smart contracts are to the rescue. Say you have additional crypto lying around and you want to earn interest on it. So you go to a crypto lending platform like AAVE or Compound and deposit your crypto worth $10,000 in a smart contract. In return, you get a different token (let us call it X token) which is a representation of your crypto along with some pre-decided interest.

Comes along another person who needs a loan of 10,000. He can put another crypto as collateral (>10,000 worth) into that smart contract and now if he tries to run away with that money, the smart contract will automatically liquidate his holdings and pay you back.

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