Lending and borrowing assets are regular processes both within traditional and decentralized finance that consist in one party giving assets to the other, with one exception that in the DeFi world, assets mean cryptocurrency, in exchange for payback based on interest rate.
The process of borrowing and lending something is one of the oldest concepts in an economy. The operation of traditional banking institutions is underpinned by the borrowing and lending services. The concept is clear and simple — borrowers take loans from lenders and pay them back with an interest that was agreed, and that’s it. Today these processes are carried out and regulated by banks as well as autonomous P2P lending facilities.
While banks facilitate loans in the fiat world, in the cryptocurrency industry this function is performed by two main digital market players — centralized financial entities such as Celsius and decentralized financial platforms such as Maker.
Centralized financial algorithms operate in a way similar to traditional fiat-based banking authorities — they take a hold of their depositors’ assets and lend them to those asking for a loan. In the meantime, the funds depositor is kept being paid their interest for providing funds to the platform. In general, the system gives an impression of being prospective and profitable, but in reality, it may come with a range of difficulties such as insider malicious actions, thefts or hacker attacks.
DeFi platforms enable users to borrow or lend assets without any centralized authority mediating the process. Thus, no person or entity has control over the assets at any moment in the lending and borrowing process. This has become possible due to the emergence of the smart contract technology powered by blockchain. Thus, the terms of each deal are encrypted to the smart contract code and are executed without the need of a third party enacting it. Unlike centralized platforms, decentralized ones can be used by anyone without users having to disclose their personal details to third parties.
How does it work in DeFi space?
If a platform user wishes to provide a loan in tokens, they send the assets to the platform via a smart contract technology that forms a deal, by which the user receives interest in the platform’s original currency.
Decentralized platforms such as Maker allow its users to lend assets by transferring them to what is called “a money market”. In other words, it’s a process of sending tokens to a smart contract that represents an independent online middleperson making the tokens accessible to other platform users.
The same smart contract generates interest and automatically assigns it to the borrower who has to pay for the loan. The interest on the borrowed amount can be paid at a later course in the platform native currency that is minted for this purpose precisely. Thus, Maker platform has its native tokens DAI that users pay interest in.
Most loans on decentralized platforms are provided with a collateral — a so-called insurance in the form of cryptocurrency. Simply put, before the loan is given, a borrower has to provide a collateral with a worth above what’s being borrowed. Such loans are called over-collateralized.
At first, this may seem ridiculous to take a loan and providing an even bigger amount as a guarantee than the loan itself. It would seem much more rational to sell the coins at the user’s disposal than to take a loan in the first place. Yet, over-collateralized loans within the DeFi space make sense.
First of all, different coins have different values. Users may need additional funds to pay any unexpected costs without having to sell their long-term holdings that they expect will rise in value in the future. What’s more, by collateralizing their assets to a decentralized protocol, users can postpone or even escape paying taxes on the held assets. Loans can also help borrowers in leveling up leverage from trading.
Limits to the loans
There are definitely limits to how much a user can take as a loan from a platform. The limit depends on two main factors — the first one being liquidity of the platform and the second one being the collateral provided.
Of course, users can’t borrow unlimited amounts, and there’s a pretty logical explanation to it. First of all, the maximum amount of assets to be borrowed from a DeFi platform depends on the amount of funds that the platform has in possession. It’s not a really big problem on a daily basis, but can become a serious issue if a user attempts to borrow a significant amount at once.
The second factor is a collateral provided to back up a loan, its quality in particular. The amount that a user can borrow directly depends on the collateral factor of the assets they supply as a guarantee — meaning the percentage of funds allowed to borrow for the provided amount of collateral. For example, a user supplying 1000 DAI as a collateral can borrow as much crypto as 750 DAI is worth, as the collateral factor for DAI is 75%.
In other words, a user who wishes to take a loan must possess funds in value no less than the loan itself multiplied by the collateral percentage. If a user meets this requirement, they can borrow assets from a DeFi lending facility.
How is interest distributed on decentralized platforms?
Lenders are authorized to chose the currency they want to provide and the smart contract to provide it with via a decentralized application that further links with the user’s cryptocurrency wallet where interest is transferred.
In short, the amount of interest that borrowers pay and lenders receive for providing assets to the platform is defined as a relationship between the amount of cryptocurrency borrowed from and lent to the platform. It’s worth mentioning that the total amount of income derived from borrowing per year exceeds the same index representing annual earning from token supply to the same platform.
Some platforms define earnings per block within Ethereum blockchain, which makes an interest a subject to change depending on the market forces, meaning demand for lending and borrowing in particular. Some platforms try to ensure that users receive stable earnings and apply to flash loans which are only valid within a single blockchain transaction as a financial instrument with no collateral required.
What risks does the lending and borrowing represent?
Decentralized platforms do bring about certain risks such as probable counterfeiting with the used smart contracts as well as fast increase in borrow APY value.
It is true that compared to centralized platforms, decentralized are considered to be significantly more secure representing credible and reliable lending facilities. Yet, DeFi lending can’t escape all risks at all. For instance, there are risks associated with the smart contract technology as APYs can change significantly in a very short period.
Such situations have already taken place when the topic of decentralized finance was all over the headlines during 2020, which has led to extreme popularity of yield farming, pumping borrow annual yields for a range of digital assets by over 40%. Such an unexpected growth in the APY value can lead to harsh changes in the amounts of interest that borrowers have to pay.
In general, the process of lending and borrowing assets on a decentralized lending platform is quite transparent and understandable for a regular user. Yet, there might be insignificant difficulties related to different terms that protocols operate on, such as the difference in wallets users should have, varying fees charged, etc.
Users are responsible for providing accurate information such as wallet address, as the blockchain transactions are final and there’s no way to cancel a transaction in case the funds were transferred to a wrong wallet.