Decentralized finance (DeFi) is an environment built on the Blockchain Network to support financial applications without the involvement of third parties. The industry has kept on booming with a total of $236B in Total Locked Value. With a growth index of over 20 fold and bullish sentiments running all over the crypto market, one focal point is that the popularity of Defi platforms is rapidly gaining traction day by day.
Defi lending, also known as Defi loaning, offers digital crypto loans in a trustless yet secure manner. It is a process whereby blockchain customers are allowed to enlist their crypto owning on the platform to be availed for lending. A borrower, on the other hand, can take up loans without intermediaries. Lenders earn interest for each loan they facilitate.
How DeFi Loans Work:
As any financial business’s goal is to make profits, holding crypto assets is not the most profitable means to earn returns, especially amidst such a volatile market. However, Investors have capitalized on this setback, and they are earning better returns from their assets after lending them out at an interest rate. There exists a variety of ways to offer crypto for loans, but lending pools are the most prevalent.
Defi lending is done through lending pools which equate to traditional loan offices in banks. Investors in the lending pools are availed with the option to collect part of their assets and avail to borrowers through smart contracts. The rules and terms of each loan are specific and written on the contract. It is advised that each potential investor or borrower conduct adequate research before settling on any pool to be involved.
Down to the logistics of borrowing a loan on the Defi platform, there has to be collateral. A borrower needs to provide something more valuable in the form of collateral to access the services. This means that before a loan is processed, said borrower is expected to deposit in the smart contract assets in an amount equivalent to what they are borrowing. For example, if you own DAI coins and you wish to borrow one bitcoin, lending pools will need you to deposit as many DAI coins to equate to the price of one bitcoin.
Suppose your loan matures and you receive it, the investor will expect you to repay it on time stipulated with the additional interest. Upon completion and clearance, the pool returns your collateral untouched.
Challenges to DeFi Lending
Traditional banks have been cashing on loans and their interests since so long ago. The most significant advantage of traditional lending over Defi is that collateral in banks is physical and assessed based on value. In case of default payment, the bank collects its worth of assets, and the case settles. Defi lending, however, with its anonymity and no physical assets involved, managing risks becomes challenging.
Defi borrowers are often required to pay up to 200% of what they wish to borrow. Despite this over-collateralization, if the collateral’s value begins to since, the lending pool will automatically use a circuit breaker and start liquidating the collateral to pay off the loan. The rules governing all lending pools ensure that the platform loses no money, and so if the collateral’s price falls 120% of the loan, liquidation starts. The borrower, in this case, ends up suffering more losses.
The opposite is quite pleasant if your loan asset spikes in value. The borrower could make massive profits and even be able to pay back the loan quicker.
Benefits of Defi Lending Provides its Users
- Improved Loan Speeds – Decentralized finances eliminate all third-party actors and entirely rely on AI computations and analytics to request loans. These tech advances help speed up the entire loan process, and when the loans are approved, lenders send their offers through smart contracts.
- Transparency – Blockchain technology keeps its customers anonymous, yet every transaction on the network has to be verified by each user on the network. The kind of transparency ensured in this environment authorizes a more accurate data analysis.
- Permissionless – As long as you are legal with a crypto address, anyone can access Defi applications regardless of their physical location all over the world. Also, there is no minimum amount of funds required to start borrowing.
- Consistency – Unlike traditional lending, where processes have to be mediated by humans probe to bias at various levels, Defi systems automate all these processes. Analyzing details of each applicant and structuring contracts are more accurate on the blockchain.
What are the popular Defi lending and borrowing platforms?
Maker is a popular DeFi crypto lending protocol that deals with borrowing DAI tokens whose value is anchored to US dollars, making it a stable coin. Any registered user can use the platform to open a vault and lock in collateral like ETH or BAT to generate debt against the collateral. Maker allows users to borrow up to 66% of the collateral value.
Aave is an open-source and top Defi lending platform that was launched in 2020. The platform operates using a non-custodial liquidity protocol to earn interests on both the deposits and borrowed assets. Aave allows lenders to put their cryptos in a pool and receive the equivalent amounts of aTokens that can be equated to cTokens of the Compound protocol. The platform varies its interests rates in relation to market demand and supply.
It can be described as an autonomous and permissionless money market protocol designed to unlock a universe of open financial applications. The platforms allow borrowing of crypto assets, earning interests, and borrowing of crypto assets against collaterals by anyone with a crypto wallet. It uses an autonomous smart contract to execute operations, management in the stored capital on the platform.
The constant growth trajectory Defi lending has been on throughout the years is clearly indicating its high potential to reshape the entire financial markets. Having a limited regulatory structure and an open-source nature means there will always be vulnerabilities, especially when dealing with a conspicuous amount on the blockchain. However, the intriguing technology behind Defi has a better opportunity to completely re-invent the technological landscape as we know it to be.
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