How Does DeFi Lending Work?
Until recently, people could borrow money only from centralized financial institutions, like banks or accredited loan providers. However, the traditional banking system is still pretty conservative, tracking users’ creditworthiness with retrospective credit records (balanced scorecard). This means that clients without a credit history can hardly get their first loan as they have no prior lending history.
The rapid growth of DeFi has solved this problem by offering a much more flexible, prospective lending system. With over $82 billion in total value locked (TVL) in DeFi projects, this industry is becoming an influential player in the global lending niche. Still, those needing a loan should keep in mind that DeFi loans work a bit differently. Here is a definitive guide to DeFi lending with a detailed explanation of all its procedures, benefits, and risks.
DeFi Lending vs. Traditional Lending
The lending practice is not new; people have been lending and borrowing money for millennia. At first, there was the lending practice with physical money, later adopted by banks providing digital funds to users’ accounts. Now decentralized lending has arrived to cover the needs of unbanked and underbanked people, and here’s how it works.
The traditional banking loan is calculated as follows: the sum of the user’s loan is added to the suggested interest rate and divided by the number of payment periods (month, quarter, half a year, etc.). Here’s a simple example:
$10,000 of a loan + 25% of interest rate (0.25 x $10,000) = 12,500
Here, the interest you’ll pay will equal $2,500; it will be added to every payment. For instance, if you take the loan for 20 months, you will pay $500 + $125 monthly. Non-collateralized loans usually come with much higher interest rates than those with collateral.
When you come to get a DeFi loan, things work pretty differently here. The borrower should provide collateral higher in value than the sum they want to borrow; the ratio is determined individually by every DeFi platform. Here are a couple of examples:
- Maker DAO’s Collateralized Debt Position (CDP) ratio is 150%, meaning that you need to provide $30,000 collateral for a loan of $20,000.
- The loan-to-value (LTV) of Aave ranges from 50% to 90%, depending on the duration of your loan. So, you will need to provide 50-90% collateral for the borrowed sum.
There is also no specified term of the loan; the fee for keeping the borrowed money is calculated daily, and the borrower can buy their collateral back at any moment. If the collateral price reduces abruptly, the borrower should be ready to add funds to avoid liquidation.
How Do DeFi Loans Work?
Now, let’s dig deeper into the mechanics of a DeFi crypto loan. Here’s how it works
- The lender who has some free crypto cash stakes their funds at a DeFi lending platform.
- The funds are locked with a fixed Annual Percentage Yield (APY) issued to the lender for every day of these funds’ use by the platform.
- Borrowers who need extra money for their operations come to a DeFi lending platform and apply for a loan. They specify the needed sum and the duration of their loan (the latter is optional, but some platforms reduce the sum of collateral for longer-term loans).
- The platform calculates the collateral needed to support the loan.
- The borrower provides the collateral and receives a loan. They may also be required to add funds if the collateral’s price falls abruptly.
- Once the borrower doesn’t need their loan anymore, they return the full sum and the calculated interest for the loan’s duration. The collateral is issued back once the loan is 100% repaid.
As you can see, the lender only needs to give digital asset collateral to the DeFi lender; the higher its price, the higher the risk of a value drop because of crypto assets’ volatility. Thus, over-collateralization is typical for the DeFi field. The difference is explained by the fact that DeFi companies don’t require any KYC or banking history from users. It’s all anonymous, and the risks for the lender are comparatively higher because of the inability to identify the lender.
What Makes It So Special?
So, what attracts people to DeFi lending protocols, making them come to borrow money from these projects instead of a more coherent and reliable banking system? Here are the key advantages of lending in the DeFi space instead of traditional finance.
- As its name suggests, DeFi is decentralized, so there is no intermediary oversight of your lending/borrowing operations.
- Anyone owning some spare crypto funds can become a lender and earn a passive income.
- DeFi loans are anonymous.
- There is no predetermined duration of the loan, meaning that you can pay lower interest if you use the money for a short period.
- DeFi platforms’ over-collateralization practice secures lenders.
What Are the Benefits That DeFi Lending Provides to Its Users?
Now that we know the basics of DeFi lending work, it’s time to clarify the pros of opting for a decentralized loan. Experts point to the following benefits of this lending approach:
- Quick loan issuance
Lending from a bank may take ages for documentation checks and identity verification. DeFi lending takes just a couple of minutes, as smart algorithms and tools do everything. You register, choose the loan option, deposit the collateral, and start using the loan in no time.
- Ending decisions favoring the client
There is no mystery or complexity about borrower rating principles in DeFi. Banks typically keep their credit scoring systems secret, so borrowers can’t be sure about their application’s outcomes until the last moment. In DeFi, if you have collateral, you will be given a loan without a problem.
- Legal compliance
Though the DeFi lending mechanism is confidential and anonymous, the platforms still track the wallets from and to which the funds are getting transferred. Thus, this lending industry complies with the legal regulations and AML principles.
- Advanced creditworthiness analysis tools
Blockchain technology is a quickly evolving sphere, so it applies cutting-edge analytical tools to help lenders and borrowers receive optimal terms and DeFi lending outcomes. Smart tools analyze borrowers’ creditworthiness, adjust APYs to supply and demand dynamics, and anticipate seasonal demand changes.
- Permissionless approach
The basic principle of blockchain is permissionless, open access to the dApps among all digital space users. Thus, anyone can lend funds to other users or receive a loan from a DeFi platform regardless of their financial status or location.
- Ultimate loan transparency
Despite the anonymous nature of DeFi transactions, all operations between crypto wallets are easily traceable and recorded in the blockchain. Thus, it is easy for all network users to track the origin of funds they receive and the route through which they pass on the blockchain system.
- Blockchain immutability
The decentralized principle of blockchain operations and using pre-coded smart contracts for transaction activation guarantee a vital feature of DeFi – immutability. Nobody can intervene in the public ledger and manipulate data to forge transactions.
- The programmability of smart contracts
Every blockchain operates based on smart contract technology, which allows automatic execution of contractual terms between the parties. Smart contracts also underlie new token and coin development, thus giving users endless freedom of activities within the blockchain.
DeFi platforms usually operate on different blockchains but still enjoy a high degree of interoperability. As a result of increasing integration and complementarity, the blockchain space gets more homogeneous, with frictionless cross-chain transactions.
The lack of intermediaries gives more power and freedom to Web3 users. Still, this DeFi feature comes with added responsibility. Thus, the users of crypto wallets and DeFi lending platforms should exercise caution and keep their funds under personal control.
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How Do DeFi Lending Platforms Help the Financial Services Sector?
With the principle of getting and giving DeFi loans explained in detail, we now need to see whether the DeFi lending sector is generally beneficial or hazardous for global finance. Here’s how DeFi lending helps the financial services sector progress and ensure broader coverage.
Lending and Borrowing
Though DeFi platforms draw some clients away from the traditional banking system, they also aid the global economy by giving unbanked people access to finance. They democratize public access to finance and allow simple loan acquisition even for those who would not get a loan from a usual bank.
A growing population of Holders believe in the long-term potential of cryptocurrencies and invest in different assets for long-term holding. However, passive storage of those funds in crypto wallets doesn’t generate any income, so crypto owners can let their money work for them at DeFi lending platforms.
Interactions with DeFi apps and platforms make crypto users more competent in the crypto universe, allowing them to choose among many earning and saving options. This way, they get more proficient in asset allocation, interest earning, and optimal management of their finances.
What Are the Popular DeFi Lending and Borrowing Platforms/Protocols?
Though the DeFi space is pretty risky for laypersons, you can reduce the risks by working with reputable and trusted DeFi borrowing and lending companies. Here is the list of top providers of decentralized loans in the modern digital market.
One of the most prominent DeFi examples is Maker DAO, the world’s top DeFi ecosystem allowing users to lend their crypto funds in exchange for the DAI token – a stablecoin pegged to USD. The platform’s unique infrastructure reduces the crypto market’s inherent volatility with the use of DAI tokens. Maker’s operations occur based on the Maker protocol under the strict regulation of the MKR holder community.
Aave saw the world in 2020, growing into one of the world’s top DeFi lending platforms in less than two years. It’s a non-custodial platform allowing lenders to deposit their funds into a liquidity protocol, earning interest from their investments. The interest is paid in aTokens – the infrastructural tokens of the Aave protocol that can be further exchanged for any stablecoin of interest. The lenders get daily APR dynamically adjusted to the current demand-supply ratio.
The Compound protocol is a universal DeFi aggregator for lucrative cryptocurrency management. It allows access to 18 markets where the users can borrow, lend, and stake their tokens for high APY/APR. The user can deposit their money to Compound, choosing the market for their lending after terms’ comparison.
How Much Does It Cost to Develop a DeFi Lending Protocol?
The cost of such a project depends on your specifications, the blockchain development company‘s location, and the complexity of planned features. As a rule, DeFi lending protocols cost from $65,000 up to $300,000+. Factor in the following aspects when calculating the quote:
- Basic app functionality
- UX/UI design
- Smart contract design and tokenomics
- QA testing and smart contract audit
- Pre-launch marketing
- Post-launch maintenance
Now you have the concept of DeFi loans explained and know the top platforms where getting or providing a loan is safe. Use this data for diving into the vibrant, lucrative niche of DeFi crypto loans to get some extra cash for your business needs, earn a passive income from your crypto holdings, or try yourself in a trader role. You can also join the market with a great DeFi lending project. Beware of the cryptocurrencies’ volatility risks, and your chances to take advantage of high APYs and great lender terms will multiply.
In a nutshell, DeFi lending is a niche of decentralized finance that specializes in lending and borrowing money. It follows a trustless approach, meaning you don’t need to pass numerous verification procedures and submit your identity documentation to get money. Thus, it is a p2p lending method where the owners of crypto assets lock their belongings on a specific platform and get a fixed fee for using those funds by borrowers. No intermediaries are involved in the process.
Overall, the DeFi lending industry is safe, as the smart contract technology of blockchains protects it. However, users who borrow money from such platforms should be aware of the volatility-related risks, as cryptocurrencies’ prices fluctuate considerably. Thus, they should calculate the risks carefully; volatility swings in the market can cause their collateral’s liquidation. Lenders risk their money as well, as the DeFi space is an innovative technology, so it has become a frequent target of hackers.
If you want to borrow some funds from a DeFi lending platform, you should register on it and offer some sort of collateral. Since the system is anonymous and non-regulated by intermediaries, the fraud risks are very high. Thus, the providers of DeFi lending services usually urge borrowers to provide collateral equaling the amount of their loan, which will serve as a guarantee of loan repayment.
If you have some spare crypto finance, locking it at a DeFi platform is a good idea. You don’t need to take everyday trading actions or worry about your funds’ intactness, which is secured by blockchain technology. People who need money will come to your platform, borrow crypto funds from the pool, and those who invested money in that pool will get a daily fee for their contribution. Thus, DeFi investments are relatively safe; the only risk you undergo is the extreme volatility of crypto assets’ prices.