What is DeFi? DeFi Lending

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DeFi has many different applications that provide alternatives to traditional finance for coinage, spending and transferring money.

Lending platforms are arguably the most popular product in decentralized finance. Anyone can borrow quickly and easily without disclosing their identity to a third party or going through the standardized checks required of traditional banks. This system has great advantages, but we should not overlook the possible disadvantages of decentralized lending.

DeFi lending operation model

The largest lending platforms currently operating in the DeFi space are Compound, Maker, Aave, C.R.E.A.M Finance and dYdX, which together generate $106 million in interest annually. They all operate in slightly different ways, but overall, the basic principles are the same.

At the heart of decentralized lending are the smart contracts that allow it to operate. The mechanism is code that executes automatically once certain conditions are met, and eliminates the need for a centralized organization to operate and manage interactions between parties. By writing the rules of a loan into a smart contract, users can pool assets and distribute them to borrowers.

As with traditional loans, borrowers need to put up collateral to make a loan. In DeFi, a borrower deposits cryptocurrency into a smart contract as collateral, with a value that is at least equal to or even greater than the value of their loan. Which currencies are used as collateral depends on the lending pool you access and which currencies are supported by the lending platform.

At the end of the loan, as the borrower, you have to pay back the money you borrowed plus the agreed interest. And then, the extra money you put in, as interest, is distributed among the lenders in the pool. That’s why people are so interested in lending money — they’re not just holding it as an idle asset, they’re putting it to work and making money out of it in the form of paying interest.

The system seems to be a win-win. Anyone who deposits collateral can borrow money, and anyone can earn interest on crypto assets by lending to others. But the system is not entirely risk-free.

DeFi The risk of borrowing

Cryptocurrencies are known to have the potential for wild price swings on any given day. What happens when the price of the collateral deposited falls below the price of the loan? Your loan will be subject to liquidation penalty. For this reason, most platforms require excess collateral, which means users must deposit a higher amount than they intend to borrow.

In fact, most borrowers typically deposit 200% of the amount they will borrow. That way, as a borrower, you’ll have some protection if the market price of the asset you’re putting up as collateral falls sharply. But in the event of a sharp fall in prices, the pool would start liquidating collateral to cover loans. That means the borrower could end up losing the collateral but still keep the amount of the loan — you’re paying for your losses. Therefore, the longer the DeFi loan period, the greater the risk. But if you are predicting that the price of an asset will soar and you want to make a quick profit so that you can easily repay the loan, a short DeFi loan is a barre way to bet.

One step further

All of the innovations in crypto are exciting and look promising. But as with everything that operates at the forefront of innovation, you need to do your homework to make sure you understand all the possible risks and figure out what works best for you.

We’ve covered some basics related to DeFi lending before, here’s a quick overview to help you figure out what to do next.

Stable currency

Many lending pools list Stablecoins as assets, such as DAI, USDC and USDT. Stablecoins are an important part of the DeFi universe, so you need to understand how stablecoins operate and what the differences are between the various stablecoins traded on the market.

WBTC

Wrapped BTC is an ERC20 token against BTC. It is widely used in the DeFi protocol and has been the main driver of liquidity in DeFi. While WBTC stands for Bitcoin, it’s important to understand that WBTC does not mean you actually own bitcoin.

Compound

Compound is played a little differently: your locked assets will be tokenized through cTokens. This pattern allows your locked assets to be traded and used in other decentralized applications (DApps) throughout the DeFi ecosystem.

Aave

As a DeFi lending protocol, Aave is similar to Compound, but has some unique features that push the boundaries of financial innovation. Flash lending, flexible interest rates, and credit authorization are all new services and hallmarks of Aave as a leader in pushing for greater expansion of DeFi.

DeFi

If you want to learn more about the strengths and weaknesses of decentralized finance, and how it could develop in the future, please read our latest research article.

What is DeFi? DeFi Lending
 

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