This article is released as a part of the Deepwaters Ponder catalog, which is intended for educational purposes and furthering the public’s understanding of decentralized finance.
Why Do People Lend or Borrow Through DeFi?
Loans in DeFi have expanded the utility of cryptocurrency and address many of the inefficient qualities inherent in traditional financial services. Through DeFi, anyone can become a lender or borrower while retaining their privacy, and smart contracts kept on the blockchain enable lenders to maintain custody over their deposited assets, as opposed to both centralized finance (CeFi) and traditional banks.
For borrowers and lenders, DeFi loans are enticing due to their permissionless protocol, which eschews the existing system of payment schedules, excess paperwork and the impact on credit scores when repaying loans. Instead, loans are at the behest of the loan-to-collateral value ratio (generally shortened to "loan-to-value") and the terms set by the lending pool. Due diligence should be done by those seeking to borrow and lend in DeFi, as terms differ across different pools and platforms.
Lending through DeFi is different from simply holding (or HODL-ing) an asset, waiting for it to appreciate, by opting to put it to use and accumulating interest distributed as a fraction of the lending pool. Borrowers, inversely, seek to increase their leverage on trades, divest capital gains taxes on an asset or ensure that their appreciating asset is not missing out on unrealized returns.
If the liquidation threshold (the ratio of loan value to collateral value) is exceeded through asset-value change, lenders can liquidate (take) the collateral posted by borrowers, thus ensuring that markets almost never leave the lender at a loss in the case of trends or volatility.
How Do You Lend Through DeFi?
Users depositing their fiat currency in exchange for tokens can add these funds to a lending pool, in order to become a lender and generate passive income.
The deposit into a lending pool is then digitally rendered on a smart contract through the blockchain, which is a protocol that executes events and records transactions. This smart contract would record that the user has become a lender for users seeking to borrow, and loan takers who meet the requirements for the contract can do so.
Lenders receive a token on the blockchain representing their initial deposit along with their respective APY (annual percentage yield) interest. The smart contracts used by protocols create lending pools which generate supply APY for lenders. Supply APY refers to the passive income earned by lenders, which is pegged to how many units they have deposited as a fraction of the overall pool.
The tokens given to lenders in exchange for their deposited assets will be determined by the exchange rates between the asset supplied and the asset-with-interest token that they receive.
UAI = underlying asset + interest token
A = underlying asset
INT = interest
A is worth 100 UAI.1
INT is worth 1 UAI.
Lender deposits A into the lending pool, receiving 100 UAI, and getting 1 INT every month through lending to borrowers taking A, paying INT.
Over two years, the lender has 124 UAI.
The lender can exchange their 124 UAI for 1.24 A.
Lender has gained 0.24 A from 1 INT across 24 months.
However, APY is determined per Ethereum block on Compound, for instance, letting volume inform variable interest rates. Interest would be received by the lender as asset-with-interest tokens, allowing a lender withdrawing their underlying asset to be paid through exchange rates. This is more complex and will be explained in more detail in a separate post.
How Do You Borrow Through DeFi?
Taking a loan through DeFi serves the same purpose as it would through traditional finance (TradFi) or CeFi. Borrowers seek to obtain short-term lump sums, in exchange for paying their loan off with interest over time, along with posting collateral. After the loan is repaid with interest, the borrower can withdraw their collateral.
Due to the high volatility of the cryptocurrency market, DeFi loans are overcollateralized, meaning that users must deposit more value in collateral than the value of the loan itself.
For example, if a borrower wishes to take out a loan to receive 1 ETH worth the equivalent of 3000 DAI, they will have to deposit 4500 DAI as collateral through MakerDAO.
In traditional finance, loans taken for goods such as cars would need to be vetted and approved by lending institutions, with the car acting as collateral. In DeFi, the collateral must be upfront and greater than the value of the loan to ensure that it is covered. The loan-to-value is continuously determined by off-chain oracles like Chainlink and price feeds informed by the activity on both decentralized exchanges (DEXs) and centralized exchanges. If the ratio of the value of the loan to the value of the collateral exceeds a specified ratio, known as the liquidation ratio, then the loan will be liquidated.
Eg. The 4500 DAI used as collateral was liquidated when the price of the 1 ETH loan grew to be worth 4250 DAI.
Partial liquidation features are being adopted by some select DeFi platforms to prevent the wide scale loss of collateral felt during flash crashes. Partial liquidation is incrementally liquidating users’ collateral as market trends persist, which is particularly useful for very brief and sudden drops in asset value. Similarly, grace periods and margin calls are useful for allowing lending to be fair for borrowers and adapt to the volatility of the market, although these features are not universally implemented in DeFi.
What Do You Need To Know About DeFi Loans?
Some cryptocurrency wallets, such as Metamask, offer users the opportunity to borrow through DeFi applications (dApps) and streamline Ethereum-based financial planning through decentralized autonomous organizations (DAOs).
DeFi can benefit both lenders and borrowers when used responsibly, as a new financial instrument which is expedient for loan approval, lending safely and borrowing easily.