DeFi lending enables users to select which money market they want to lend to and earn interest from, depending on the market’s yield.
after reading this, you'll understand:
Concepts of over-collateralization, under-collateralization, and flash loans.
How DeFi platforms and lending protocols function.
The risks of participating in DeFi lending.
Since 2020, decentralized finance has seen a massive increase in use. Over the past two years, Dune Analytics reports a growth to around 4 million users on DeFi applications such as DeFi lending. That’s nearly 40 times larger than the 2020 user pool.
Whether it’s currently out as a loan, acting as collateral, or in a liquidity pool, there’s about $40 billion dollars currently locked in cryptocurrency, according to DeFi Pulse. This is a drop from April 2022, when the total value locked was near $78 billion.
DeFi is the newest evolutionary phase of the lending and borrowing market. Traditional financial instruments, using trusted third parties as intermediaries that give loans based on credit, have persisted since the industrial era. While the rest of the world has been transformed by the advent of the internet, borrowing assets in this financial system has stayed pretty much the same.
Decentralized finance is different. It provides a means for individuals to maintain self-custody of assets while earning interest on them. Using blockchain-based smart contracts, users can select which money market they want to lend to and earn interest from, depending on the market’s current annual percentage yield (APY). That market will provide the lender with a new token that embodies the worth of the original loaned token and its gained interest.
These lending pools are universally accessible, without depending on personal information like credit scores or socioeconomic background. Theoretically, this is a more equitable system than traditional financial institutions. Decentralized applications can provide financial access for underbanked populations, groups who often cannot obtain loans or open bank accounts.
In addition, a home loan with a traditional lender considers the house to be collateral for the loan. If you stop paying, the lender can seize your house. In DeFi, there’s no house, only tokens.
In traditional lending, a banker sometimes requires a borrower to put up collateral to secure a loan. For a home mortgage, for example, the house is collateral. If the borrower defaults, the lender takes possession of it. This is called a secured loan. For an unsecured loan, like credit card debt, the lender does not require collateral. Interest rates tend to be higher for unsecured loans, because the lender is at greater risk — having no collateral to claim in case of default.
To borrow in DeFi, users must use cryptocurrency collateral in the form of other tokens that are worth more than the value of the loan itself — usually at least 1.5 to 3 times more. The smart contract regulating the loan takes custody of the collateral until the loan is repaid. Over-collateralization results in most of the parties involved in lending pools already hold substantial crypto assets.
Why would people give up control of a larger amount of cryptocurrency to obtain a smaller amount? Some people are trying to avoid capital gains taxes on their current crypto assets. Some users think their crypto assets will see a long-term rise in value. Rather than spend cryptocurrency, they use it as collateral to gain more to use in the moment. When they repay the loan, the collateral cryptocurrency that they regain will have increased in value. Lastly, some people borrow to acquire funds to use as leverage for different trading positions.
Another benefit of DeFi loans is that there are no time limits to borrow funds. As long as the collateral value stays greater than the value of the borrowed amount, the loan can persist for any span of time. However, if the collateral’s value dips below a target amount or the original value of the loan, the smart contract triggers a self-executing liquidation of the collateral.
Under-collateralization has been an elusive goal for the DeFi market. With over-collateralization, the creditworthiness of the borrower doesn’t matter. The collateral is in hand. The challenge for the DeFi market is how to loan cryptocurrency to people who don’t have enough assets to over-collateralize.
DeFi proponents want to make lending far more accessible while still preserving the values of decentralization. The market is working out several ways of solving the problem. Some methods involved establishing creditworthiness entirely through the blockchain while others would use off-chain information and/or possessions as a basis for making loans.
Flash loans are another way to beat the under-collateralization problem. They require a high degree of expertise, however, and are nothing like traditional loans. These exchanges take place in seconds or minutes, rather than the months or years taken to repay traditional loans. If the loan is not repaid within the short amount of time allotted, the smart contract cancels the loan and resets things as if it had never happened. Flash loans typically are used for:
Collateral swaps and interest rate swaps. A borrower sees that another platform is offering better loan terms and obtains a flash loan to allow for a quick swap to pay off the first loan and get a better deal with a new loan.
Arbitrage. Someone obtains a loan and uses it to buy cryptocurrency on one exchange, sells it for a higher price on another exchange, pays off the loan and interest, and keeps the difference.
While flash loans are intriguing, they are not likely to become commonplace because of the level of expertise needed to pull them off properly. Also, they can be vulnerable to hackers. Other methods of issuing under-collateralized loans will have to mature to make this form of DeFi more mainstream.
Two of the leading decentralized applications are AAVE and MakerDAO, holding $4.9 billion and $7.9 billion currently locked in cryptocurrency, respectively. Different lending platforms have different strategies to incentivize and protect lenders and borrowers from the volatility of the crypto market.
Launched in 2020, AAVE offers a money-market based approach where lenders or borrowers can choose which token they want to trade in. Once deposited in a chosen money market, the lender receives AAVE’s native token, AToken, amounting to their original deposit and added interest. Lenders’ ATokens can also be used as collateral if they’d like to borrow in a different AAVE money market, perhaps offsetting their interest rate on borrowed assets with the income gained from their loaned assets.
AAVE offers varying interest types. In certain markets, “Stable APYs” buffer interest rates from most spikes while changing interest in the long-term. AAVE also provides flash loans in which users can borrow for limited, short periods and don’t have to provide upfront collateral.
In addition to native tokens, another financial instrument in crypto is the “stable coin.” Stable coins are basically the crypto version of traditional currencies. The most famous is the DAI, founded by MakerDAO. MakerDAO launched the DAI in 2017, with the goal of pinning the value of the DAI to the USD at a fixed rate. So, one DAI in your crypto wallet is roughly equivalent to one USD in your back pocket.
To maintain this value, Maker follows a set of smart contracts established by its DAO members that works to decrease DAI’s market volatility. By investing in Maker, your interest rates generate DAI of a known worth.
Other examples include the Compound protocol, which supports more than a dozen cryptocurrencies, including DAI and ATokens. Meanwhile, Hedera's HBAR cryptocurrency is listed on BlockFi — a crypto lending platform — and is available on cryptocurrency exchanges.
To invest in crypto loans, you need first to open a crypto wallet. With the wallet, you’ll be able access and participate in Defi protocols, trade major currencies like Bitcoin and Ethereum, and use decentralized or centralized financial applications. Note that, at present, most DeFi systems are built on Ethereum. Then choose which of the DeFi lending platforms you’d like to invest in and connect your wallet. Start your DeFi investment portfolio through crypto loans and have fun monitoring your assets!
DeFi’s counterpart is CeFi, or Centralized Finance. CeFi is a more user-friendly introduction to crypto lending platforms. It functions more closely to traditional financial models, offering crypto debit-cards and services comparable to traditional savings accounts, though with conceivably higher yields. Still, you’re able to buy, sell, lend, or borrow your crypto assets. Using CeFi is a similar process to DeFi; open your wallet and take your pick of the financial platforms. However, depending on the application used, CeFi doesn’t provide fixed interest rates like in traditional finance, instead it relies on the ratio of lenders to borrowers in a particular market, just like DeFi.
The arguably biggest risk of lending and borrowing in DeFi is the way that interest rates can change quickly. APYs are variable for each money market based on its lending-borrowing demand. If you don’t keep a close eye on interest rates, they could balloon without you noticing and your assets could be liquidated. In most major DeFi platforms, the peaks in liquidations coincide with spikes in APY volatility.
Also, there’s pressure on the user to have in-depth knowledge of the lending market: substantial money can be lost through simple user error. Users especially need to understand and keep tabs on how over-collateralization of tokens impacts the coin markets they’re interested in.
DeFi also retains all the benefits of blockchain technology and smart contracts, including reduced transaction fees, greater transparency, and better security through decentralized ledgers. However, as open source blockchain technology, there is always the risk of hacking. Even CeFi applications are not able to provide insurance against security breaches in the way that the Federal Deposit Insurance Corp. (FDIC) and the Securities Investor Protection Corp. (SPIC) offer protections in traditional finance.
Decentralized finance is revolutionizing how financial models can work on a global scale. From cross-border payments to impacting the open market, DeFi lending protocols are the way of the future. As real-world assets become tokenized, institutions adopt web3 technologies and standards, and legal frameworks evolve to cater to DeFi, it’ll become increasingly practical and user-friendly to borrow and lend assets digitally.
Hedera's native token, HBAR, has been listed on BlockFi — a leading crypto lending platform. That's just one of many applications offered by the Hedera ecosystem to enable web3 reatil users to participate in its DeFi ecosystem. Developers can participate in DeFi by building native token-based applications and protocols or use the Hedera Consensus Service to create an auditable log of verifiable, timestamped events for financial applications.