A deeper dive into DeFi, Part I: Lending
by Alyona Shepilova
Jun 16, 2023
What is DeFi?
In our last article, we said that DeFi is a multitude of financial products and services that exist on blockchains and are powered by digital assets. As such, DeFi is an alternative to traditional finances.
One of the main differences – and, we'd argue, advantages – of DeFi is that it doesn't have intermediaries. Take a simple transaction when you're buying a cup of coffee. You swipe your card, you get the coffee. Quick and uncomplicated, right? Wrong (sorry). Because when you swipe your card, the merchant first needs to contact the payment processor for authorisation, which then contacts the issuing bank. This one gets back to the payment processor, and the latter finally reaches the merchant and tells them to approve or deny the transaction. All of the entities mentioned above are intermediaries, and you can be sure they charge for their help. Well, DeFi doesn't have any of those because this role is played by smart contracts.
DeFi exists in a decentralised environment of the public, permissionless blockchains. It's not about Ethereum only, although it is the most popular option. DeFi services are encoded into smart contracts, which are pieces of code that execute themselves when certain conditions are met. For example, send money from user A to user B every Friday if user A has money to send. Code is impartial, so you trust it. It also doesn't charge you, and it's quicker and less* faulty – as there's no human factor, and it's all automatic.
*Codes are written by humans, and humans err. This is how we get buggy codes that get exploited.
So, DeFi has this going on for it. And there are other advantages, too. For one, blockchains can't be censored by governments or banks, so no one can deny you services. Depending on where you live, you may also access a fuller spectrum of services that would otherwise be unavailable to you. DeFi is also more transparent, as anyone can inspect the code and see what's in there. It does require special knowledge to understand the code, but technically anyone can still take a peep if they like.
What DeFi products are there?
There are six major DeFi categories:
Decentralised exchanges, or DEXs, for short
We'll now examine each category one by one. Allow us to start with the most prominent offspring of DeFi – the credit category – also known as DeFi lending.
What is DeFi lending?
DeFi lending (borrowing, loans, credit, a rose by any other name) is when a person who has some spare crypto assets chooses to lend them. Then there's another person who borrows by providing collateral. It's very similar to how traditional banks work, only it's on a dapp and is executed by a smart contract.
What's in it for the DeFi lender?
Suppose you hold some crypto. You hope that the price of your assets will rise and you'll make some profit. The value of your investments can also decrease because cryptocurrencies are volatile. In the meantime, you're not earning anything on your crypto. But if you lend your assets, then you can generate interest on your loan.
There are two main advantages. First, if you're not eligible to lend your funds at a traditional bank, you always will be with DeFi lending. Second, interest rates for DeFi lenders are usually (much) higher.
What's in it for the DeFi borrower?
When borrowing money from a bank, your collateral wouldn't exceed 100% of the loan. DeFi borrowing is quite another story. You will be asked to collateralise it at 150% or 200% of the loan value when applying for a loan. This begs the question. Why would anyone in their right mind borrow from DeFi? If you need money, you certainly can't lock even more money in a smart contract, all to obtain a smaller amount? What would even be the point?
And the point is speculation.
Please note that the examples listed below are for illustrative purposes only. This is not investment advice.
Imagine that you're a long-time holder, and it's been going really well for you. Now, if you decide to sell, you might fall victim to a massive tax bill. Clearly, you'll want to avoid this. So, what do you do? You might take a loan in stablecoins and then exchange them for fiat. Now you have cash, and you didn't need to sell your crypto assets.
Or, you don't want to sell them because you believe that your assets will rise in price. Meanwhile, you'd like to have a source of additional income. Then you borrow against the asset you already own and put the borrowed asset into another project. The one where the earn rate is higher than your interest rate with your lender.
Pretty complicated stuff. You need to calculate your risks carefully and be sure you know exactly what you're doing, as you can always lose your collateral.
How does DeFi lending work?
The lending rules are written into smart codes and differ from platform to platform, so it's essential to research before you decide to participate, whether as a lender or a borrower.
Lenders supply their assets to a lending pool from which the borrowers borrow. To do so, the latter must provide collateral above the loan value. The collateral itself can be in a variety of currencies. Once the loan is finished and the borrower repays the loan amount + interest, they get their collateral back. So, instead of having to sell the collateral to get hold of another asset – the borrowers get access to that asset to do as they please (trade, lend etc.) and retain the collateral. And the interest, in turn, gets shared between lenders, so, in theory, everyone's happy.
Now. What would have happened if the asset used as collateral had fallen so low it no longer covered the loan amount? It would make no sense for the borrower to repay the loan if they lose less than they gain, right? So, lending platforms must impose safeguards to protect creditors and the lending pool. They do so by liquidating the collateral to settle the loan amount as soon as collateral falls below a certain point (but when it's still worth more than the borrowed amount). Liquidation here basically means that someone buys your collateral off of you at a discount. Once the collateral gets liquidated, the loan is considered repaid.
Let's move on to decentralised exchanges or DEXs.