Understanding Lending and Borrowing in DeFi (Decentralised Finance)

INTRODUCTION

Decentralised Finance or DeFi is quickly gaining prominence in today’s world. Earlier it was a niche in the crypto space however now, it is gaining recognition amongst the general masses. The idea of getting a loan or lending to others through a computer code, without the need for a ‘trusted intermediary’ like a bank or NBFCs.

And in the last few years, the DeFi scene has seen an explosion of innovation and development of various different products that can mirror already existing products offered by these banks and NBFCs, with the only difference of it happening a completely decentralised fashion. Everything from lending, borrowing, exchanges and yielding – everything can happen through DeFi in a more efficient and decentralised manner.

WHAT IS DEFI?

So DeFi, short for decentralised finance is essentially a new emerging form of financial technology based on a blockchain, or rather a system of distributed ledgers that provide greater security and robustness. Thus, this system is essentially able to remove the need for and the control that banks and institutions have on money, financial products and services.

Some key features that are attracting people to shift from Traditional to Decentralised Finance include:

• eliminates enormous amounts paid as fees to banks and financial companies for their services
• money is held directly with the user in a digital wallet rather than with a bank
• anyone with hardly an internet connection can use it without the need for approvals
• funds can be transferred almost instantaneously

WHAT IS DEFI LENDING AND BORROWING?

DeFi based lending and borrowing on the outset is exactly like the lending and borrowing you’d expect in a typical lending and borrowing scheme in traditional finance. The only difference is how the mechanism works behind the scenes. So basically, DeFi lending protocols are built to offer crypto loans in a completely trustless manner, i.e., without the need for intermediaries and also allow users to enlist their cryptos on the platform for lending purposes.

In this system, a borrower can directly take a loan through the decentralised DeFi lending protocol – in a process called P2P lending.

The underlying value of the cryptos assets that you own may rise or fall but if they are sitting idly in your wallets won’t do anything else. It is important for any asset class to be able to provide some passive income along with price appreciation over time. Say in the stock market, you can hold stocks for the price appreciation but you get some dividends from time to time too.

So DeFi lending and borrowing can be a means by which crypto asset owners can earn some passive income off of their holdings by means of giving it out as loans and then generating an interest on it. There are multiple hugely popular DeFi lending space today which have billions of dollars in total-value-locked (TVL). Two of the biggest names in DeFi lending protocols out there are MakerDAO (MKR) and Aave (AAVE), which have $8.7 billion and $7.3 billion in TVL respectively.

DEFI LENDING VS TRADITIONAL LENDING

HOW DOES LENDING & BORROWING WORK IN DEFI?

Source: leewayhertz.com

So, the process of disbursement of loans in a DeFi protocol happens via a process described in the image above. Users with some extra cash can pool in their funds and distribute them amongst borrowers using programs called smart contracts. Smart contracts are essentially computer codes that run on the blockchain network and adhere to a few set rules.

There are various ways in which interests are distributed to investors, thus it is recommended to invest time to research and identify your interest type. In the same way for borrowers, each pool will have a different approach on how to borrow.

DeFi lending and borrowing is slightly similar to traditional borrowing in some ways however. While taking a loan from a bank, it demands a collateral in exchange for the loan. For example, if it is a car loan, the car itself becomes the collateral and if the person taking the loan isn’t able to pay it back, the bank can seize the car to repay the loan. The same principle applies to decentralised system, with the only difference being that the system is autonomous and digital so doesn’t involve physical property being used as collateral. To get a loan, the borrower needs to offer something that has a value greater than the loan amount.

Here, smart contracts are employed to deposit the amount of currency of at least equal value of the loan amount and collaterals can be of different varieties. One crypto can be put in as collateral to borrow another crypto. One could probably take a loan of one Bitcoin by paying the value equivalent to a Bitcoin in dollar backed stablecoins. This is how DeFi protocols tend to work in the space.

WHY BORROW & LEND IN DEFI?

Lending and borrowing in DeFi offers a slew of benefits that centralised finance options can’t. Some of the most important benefits of DeFi lending and borrowing include much higher efficiency, access and transparency in the process as compared to CeFi. DeFi also allows people to become a borrower or lender without having to hand over personal information for KYC (know your client) requirements and procedures.

Also, in the case of DeFi, borrowers and lenders do not have to hand over the custody of their funds as is the case with CeFi. This means that the user always has access to their funds at all times. This is enabled through the use of special smart contracts which run on open-source blockchain networks like Ethereum.

ADVANTAGES & DISADVANTAGES OF DEFI LENDING & BORROWING

ADVANTAGES

• DeFi lending and borrowing have greater efficiency in disbursing loans
• DeFi protocols are open-source in nature and hence have greater transparency
• There is no need for anybody’s permission to obtain a loan
• No need for KYC procedures and sharing of data
• DeFi is completely decentralised and anonymous
• This is a great way to earn passive income out of your crypto holdings
• Borrowers are required to over-collateralise to protect against sudden price drops

DISADVANTAGES

• Smart contracts can be vulnerable to malicious attackers who try to exploit bugs within the code
• Governments may be against the idea of no-KYC lending and borrowing over money laundering concerns
• Anonymity can also be a concern for law & order authorities of nations

Additional Read: Top DeFi Tokens

IS THERE A CAP ON HOW MUCH MONEY ONE CAN BORROW?

Technically, the cap to how much money one can borrow in a DeFi lending protocol simply depends on two factors:

1. DeFi protocol’s liquidity – obviously you cannot borrow more funds than what is there is the lending pool of the particular lending protocol
2. Collateral factor – the second factor is how much collateral the borrower can put down against the borrowing amount

WHAT ARE THE MECHANICS BEHIND DOLING OUT INTEREST RETURNS IN DEFI?

The interest rate that lenders receive and borrowers have to pay is dynamically calculated by using the ratio that exists between the supplied and borrowed tokens in a particular market. Generally, the borrow annual percentage yield (or APY) us higher than the supply APY in relation to one particular market.

Maker is one of the most unique DeFi crypto lending platforms, and also the biggest by total-value-locked as on 18 August, 2022 – according to DefiLlama, at around $8.7 billion TVL. This DeFi protocol only allows borrowing of DAI tokens. DAI is a stablecoin which is pegged to the US dollar. Anyone can make use of Maker to open a vault, to lock in collateral like ETH or BAT and generate an amount of DAI stablecoin as a debt against that collateral, which totals upto 66% or two thirds of the collateral value. It also encourages users to participate in operational earnings through governance fees, which acts as interest rates for the network.

2. AAVE

Aave is an open-source lending protocol and is one of the most popular DeFi protocols released back in 2020. Aave works as a non0custodial liquidity protocol for earning interest on deposit and borrowing assets. This platform allows lenders to deposit their cryptos in a liquidity pool and Aave algorithmically adjusts APYs depending on the demand and supply.

3. COMPOUND

Compound (COMP) is an algorithmic and autonomous money market protocol that unlocks a universe of decentralised financial applications. It allows users to deposit their cryptos, earn interest, and also borrow other crypto assets against them. Smart contract automate the entire process of management and storage of capital on the platform. It is a permissionless protocol meaning anyone with a crypto wallet and an internet connection can freely interact.

Additional Read: Top Crypto Projects by TVL

CONCLUSION

In conclusion, it can definitely be agreed that the decentralised finance ecosystem is growing and will continue growing at a breakneck pace and try to make their services as good as existing centralised finance options, keeping the principles of decentralisation and openness in mind.

However, this is a space that comes with an innate risk and hence, users who want to avail of this functionality should ensure that they do their homework before they decide to put their cryptos into these DeFi protocols, or even if they want to take a crypto loan through DeFi.

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