Financial freedom and inclusivity have been hot topics for many years. Nonetheless, it took bitcoin to popularize the strange concept that a decentralized computer network can produce solid money.
And just as Bitcoin raised the possibility of money without a central bank, Ethereum developed borrowing without the involvement of commercial banks. In addition to decentralized exchanges, lending dApps generated $5 billion in revenue at the end of 2022.
Optimized borrowing processes
So how does DeFi lending work?
While a number of digital “neo-banks” have streamlined the borrowing process over the past decade, most customers have to go through a tedious process to obtain a loan. The reason is simple: the lender wants to ensure that a borrower is worth the risk of default.
- Customers must verify their identity
- Customers must undergo a credit check
- Customers may need to speak to a credit broker to obtain approval
- Customers may have to wait for credit to be approved
Few of these TradFi hurdles exist in DeFi as decentralized applications are hosted on a public blockchain; They can be accessed without permission, credit history and ID verification.
Anyone with internet access can illicitly borrow assets without speaking to anyone. These are the advantages of DeFi over TradFi. Nevertheless, there are some disadvantages of automated lending:
- In addition to collateral, a traditional bank can also issue unsecured or unsecured loans based on criteria such as creditworthiness, occupation and income. In DeFi, collateral must always be present to lend money and often must be over-collateralised as a safety net against debt liquidations and crypto volatility.
- Because banks are regulated by the government, they typically insure customer funds up to a certain threshold. For example, in the United States, the Federal Deposit Insurance Corporation (FDIC) insures depositors at registered banks for up to $250,000. Although there are also decentralized insurance solutions in DeFi, they are still in their infancy.
How does DeFi borrowing work?
Everything in decentralized finance is governed by smart contracts. Just as digital banking has largely replaced branches and cashiers, smart contracts automate any activity that can be logically or legally defined.
These smart contracts, in turn, are embedded in a public blockchain, making them public and auditable.
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How DeFi lending works:
- Developers program smart contract logic to govern the conditions under which a loan is taken. Smart contracts exist on a blockchain that are offered to users through a user-friendly interface – dApps.
- The users themselves (lenders) provide liquidity to facilitate borrowing. They are called Liquidity Providers (LPs) and deposit their funds in smart contracts called Liquidity Pools. LPs are incentivized because they get a cut when borrowers tap into these pools to borrow digital money.
- Borrowers only interact with the liquidity pools themselves, not with other users who have injected liquidity into them. Since there is no human involvement, only computer logic, there is no unsecured loan in DeFi either.
- Depending on the type of collateral deposited for a loan, borrowers are confronted with different collateral ratios. For example, stablecoins are exempt from crypto volatility, so they are most commonly used as capital-efficient collateral.
After the borrower chooses the type of digital asset for collateral, they see how much collateral is required, in addition to choosing a variable or fixed rate. This annual percentage return (APY) goes to liquidity providers, making them take on the role of private banks.
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All lending/borrowing dApps are accessible with a non-custodial wallet like MetaMask conveniently integrated into a web browser. Then, when visiting any lending dApp, the user simply connects their wallet, which needs to be funded to post collateral for a loan.
Unlike banks, the team behind the DeFi platform itself typically earns only a tiny portion of revenue through fees. They themselves can be adjusted at any time by the community thanks to the platform’s governance token.
For example, as one of the most popular lending dApps, Aave has a governance token AAVE, which gives users voting rights in platform development and serves as a liquidity booster against debt risk.
Restrictions and Risks of DeFi Borrowing
Aside from the lack of unsecured lending capability, DeFi’s decentralization can also become a downside. Since these lending platforms are completely dependent on other users to provide liquidity, there may be times when there is insufficient liquidity.
As such, there is often a cap on the amount of loans that can be taken out. In addition, users must carefully choose what type of assets they wish to use as collateral. For example, although Ether (ETH) is the second largest cryptocurrency, its weekly value is still volatile compared to a fiat currency.
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This is not good when used as collateral as every smart contract has a liquidation threshold. For example, if ETH has an LTV (loan-to-value) percentage of 80%, this means that in order to lend 80 ETH, the borrower must deposit 100 ETH as collateral. With these different LTV ratios, smart contracts give borrowers liquidation headroom if the value of the collateral falls significantly relative to the loan value.
Stablecoins lack such price volatility, which is why their LTV percentage is often over 90%. Because of this, stablecoins are the most commonly used asset for DeFi borrowing, as we can see from one of the most popular dApps for lending – Compound.
Once the LTV threshold is exceeded, the borrower’s collateral is automatically liquidated without any questions being asked as there is no human around to ask. The moment the borrower enters into a Collateralized Debt Position (CDP), their funds are held in a smart contract that is not released until the loan is repaid.
We’ve already seen what a massive credit liquidation event looks like when Terra’s UST algorithmic stablecoin was depegged from the dollar in May 2022. Terra’s main lending dApp, Anchor Protocol, has had $1.32 billion worth of liquidations.
To mitigate the risk of their collateral being liquidated, borrowers will not only use stablecoins, but will also borrow less than they can to give themselves additional leeway.
What are the most popular dApps to rent?
Due to their decentralized nature, rental dApps with the highest liquidity tend to be the most popular. This snowball effect is akin to Twitter gaining social media dominance despite the existence of dozens of other apps with the same functionality.
The five most popular dApps to get anonymous loans are the following:
- Aave – very flexible platform with high liquidity and the widest variety of collateral types
- Compound – sets interest rates on loans algorithmically, depending on available liquidity
- Liquidity – borrowing with no interest rate due to the unique dual tokenomics
- MakerDAO (Oasis) – Using DAI stablecoin as a multiply collateralized asset.
- Alchemix – Novelty of self-repaying loans that reduce the risk of liquidation.
In this early phase of DeFi, many users stick with the most popular dApps because they are best verified through code audits. Likewise, they are more resilient to rug pulls, which happens when whales (high net accounts) withdraw liquidity from the platform, as was the case with Terra.
Disclaimer for the series:
This series article is for general guidance and information only for beginners participating in cryptocurrencies and DeFi. Nothing in this article should be construed as legal, business, investment or tax advice. Consult your advisors for all legal, business, investment and tax implications and advice. The Defiant is not liable for lost funds. Please use your best judgment and exercise due diligence before interacting with Smart Contracts.
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