One of the key features of the cryptocurrency industry is the elimination of intermediaries that put up barriers to participation in the financial system. DeFi lending is a prime example of this.
Read on to learn what DeFi lending is, how it works, and which decentralized lending platforms you can use to earn interest on your crypto assets.
What Is DeFi Lending?
Decentralized finance (DeFi) lending enables peer-to-peer borrowing and lending of assets without the involvement of traditional intermediaries like banks or financial institutions.
DeFi lending is built on blockchain-powered smart contracts that automate and secure the transaction process, ensuring transparency, security, and efficiency in the lending process. Users can either lend their crypto assets to earn interest or take out collateralized loans while paying interest, all in a decentralized manner.
How Does DeFi Lending Work?
DeFi lenders deposit crypto assets into smart contract-powered protocols that supply liquidity pools. DeFi borrowers access these pools, securing crypto loans by over-collateralizing with crypto assets. Interest is paid to lenders by borrowers who took out collateralized loans.
Let’s take the example of Compound Finance, which runs on the Ethereum blockchain. Lenders supply crypto assets to a liquidity pool to make them available for borrowers. The lender receives cTokens in return and can redeem them for their underlying assets at any point. Interest from the loans is also in the form of cTokens. Additionally, lenders also receive COMP tokens as an additional incentive for providing liquidity to the lending protocol.
For a borrower, the process starts with providing crypto assets as collateral. The value of the collateral determines the borrowing power, which determines the loan limit. The borrower gets their collateral back once the loan and interest are paid.
Top DeFi Lending Protocols
Now, let’s take a look at some of the most popular DeFi lending protocols in the market.
Aave uses the lending pool approach, where the interest depends on the utilization rate of the pool’s assets. The interest rate increases with the value of the loans, enticing the investors to deposit more capital. If the loan amounts are low, the low interest rates entice borrowing.
The platform also offers uncollateralized loans called flash loans. Users can borrow large amounts of crypto without any collateral, provided they pay it back within the span of one Ethereum block. Additionally, the borrower must pay the one-block interest fee.
MakerDAO focuses on creating a crypto-collateralized stablecoin, DAI, pegged to the USD. The DAO members use the governance token MKR to run the project.
A borrower wishing to access the lending services on the platforms starts by depositing crypto to open a Maker Vault position. The borrower can then withdraw DAI with the allowed amount subject to the value of the collateral. A stability fee is also payable.
On the decentralized trading platform dYdX, users can access a range of services, including margin trading, lending, and borrowing. In addition to collateralized loans, dYdX also offers uncollateralized flash loans payable within the same blockchain transaction. The platform doesn’t charge any fees for flash loans.
Pros and Cons of DeFi Lending
DeFi lending offers various advantages.
- Speed: Replacing an intermediary with a smart contract means all it takes to get a loan is to meet the terms. Disbursement is immediate.
- No credit checks required: Every borrower faces the same policies since the processes are automated. No paperwork needs to be filled out by borrowers or lenders. Collateralization replaces the need for credit checks.
- Transparency: The transaction details are available on public blockchains where every interested party can access and verify them.
There are several disadvantages associated with DeFi lending.
- Cost: When the network is congested, users incur higher gas fees.
- Lack of a neutral party: Neutral 3rd parties help ensure seamless transactions. The DeFi lending protocols eliminate intermediaries who review transactions for any human errors and take responsibility for some of the mishaps beyond the users’ control. Consequently, a third party cannot address any issues resulting in losses.
- Liquidity concerns: The crypto industry’s volatile nature can cause sudden and significant declines in the liquidity available.
- Security risks: The publicly available smart contract code can be the target of hackers. If any bugs exist, they can exploit them to carry out attacks.
- Market risk: The crypto industry’s volatile nature can lead to significant interest rate changes that can negatively affect both parties depending on the direction of the market movements.
Defi Lending vs. TradFi Lending: What’s the Difference?
DeFi lending differs fundamentally in its operational model from the lending markets in the traditional financial services industry.
- Traditional lending relies on centralized financial institutions. In contrast, DeFi lending operates on blockchain-based platforms, using smart contracts to remove intermediaries.
- DeFi platforms, accessible globally with just the internet and a crypto wallet, stand in stark contrast to TradFi’s often restrictive documentation and regulatory barriers.
- For loans, DeFi emphasizes over-collateralization with digital assets, while TradFi evaluates creditworthiness.
- DeFi transactions are transparent and verifiable on the blockchain, whereas TradFi’s operations remain more opaque, held within institutional frameworks.
- On interest rates, DeFi employs algorithm-driven adjustments based on market dynamics, while TradFi rates stem from institutional decisions influenced by factors like central bank benchmarks.
While DeFi lending offers crypto holders a potentially lucrative way to earn investment income paid on crypto, investors need to do their own research to understand the risks it entails and to ensure they only use reputable lending platforms when deploying capital in the DeFi markets.