There are many different applications in the DeFi space that provide an alternative to the way money is made, spent, and sent through traditional finance.
Loan platforms are arguably the most popular product in decentralized finance. Any individual can take out a loan quickly and easily without having to disclose their identity to a third party or go through the standardized checks you normally would at a traditional bank.
There are major advantages to this system, but we shouldn’t overlook the downsides that may arise from engaging with decentralized lending.
How DeFi loans work
The biggest lending platforms operating in DeFi are Compound, Maker, Aave, C.R.E.A.M Finance and dYdX generating a total of $106 million per year in interest. While they all work a little differently, on the whole the fundamentals are the same.
At the core of decentralized lending are the smart contracts that make it work. These mechanisms are pieces of code that self-execute once certain conditions are met and remove the need for centralized authorities to administer and manage interactions between parties. Using smart contracts, users are able to pool their assets and distribute those to borrowers with the rules of the loan written into the smart contract.
Like in traditional loans, borrowers need to put down collateral in order to take out the loan. In DeFi, borrowers deposit crypto into the smart contract as collateral that is at least equal to or even exceeds the value of the loan. The currencies you can use as collateral largely depends on the lending pools you are accessing, and which coins are supported on the lending platform.
At the end of your loan, as a borrower you need to pay back the coins that you borrowed plus the agreed upon interest. The extra funds that you deposited as interest are then distributed across the lenders in the pool. This is why people are interested in lending their coins – instead of just holding assets in an idle fashion, their funds are put to work and generate more money in the form of paid out interest rates.
The system looks like a win-win for everyone. Anyone can take out a loan when they deposit a collateral, and anyone can generate interest on crypto assets by lending out to others. But the system isn’t risk free of course.
The risk of DeFi lending
As we all know, crypto prices have the tendency to swing wildly on any given day. What happens when the price of the deposited collateral drops below the price of the loan? Your loan would be subject to a liquidation penalty. For that reason, most platforms require over-collateralization meaning users would have to deposit a higher amount than the amount they intend to borrow.
In fact, most borrowers usually deposit 200% of what they will borrow. That way, as a borrower you are somewhat protected during significant price drops in the market of the asset you are putting down as collateral. But in the event of huge price drops, the pool will start liquidating the collateral in order to cover the loan. That means borrowers may end up losing their collateral while keeping the loaned amount – paying for the loss on their end. For that reason, DeFi loans are riskier the longer the time-period. But if you’re speculating that prices for a certain asset will spike and you want to make a quick profit which allows you to pay the loan back easily, then short-term DeFi loans are a way to multiply the stakes.
As with anything in crypto, things are exciting and hold a lot of promise. But as with anything operating on the bleeding edge of innovation, you need to do your homework to make sure you understand all the risks involved and figure out what’s best for you.
We’ve covered some essential topics related to lending in DeFi before, so here’s a quick overview to help you figure out the next step.
Many of the lending pools will have stablecoins listed as assets such as DAI, USDC, and USDT. Stablecoins are an essential component of the DeFi universe so you need to know how they work and what the difference is between the wide variety of stablecoins trading on the markets.
Wrapped BTC is an ERC20 coin that represents BTC. It is used across DeFi protocols and has been a major driver of liquidity in DeFi. You should understand that WBTC represents Bitcoin, but it is not the same as actually owning Bitcoin.
Compound does things a little differently: your locked assets are tokenized using cTokens. That model makes your locked assets tradeable and usable in other decentralized applications (dApps) across the DeFi ecosystem.
As a DeFi lending protocol, Aave is similar to Compound but with a few distinctive features that push the boundaries of financial innovation. Flash Loans, flexible rates and credit delegation are all new services and hallmarks of Aave as a leader in the push for greater DeFi expansion.
If you want to know more about the strengths and weaknesses of decentralized finance and what its future holds in store, read our latest research article.