While the concept of financial ‘lending’ has been around for eons, DeFi lending is a recent innovation and operates through the DeFi lending platform or DeFi protocols that offer cryptocurrency loans in a trustless manner.
The DeFi space is independent of any central authority, which is a departure from the traditional financial system. DeFi lending permits holders to place their coins into the DeFi loan platforms and earn interest, without any intermediaries.
The Decentralized Finance or DeFi ecosystem is a collection of financial apps built using blockchain technology. The DeFi ecosystem started on the Ethereum network and is built on self-executing smart contracts that don’t require a third-party intermediary. To establish decentralized assets and applications and protocols, it relies on peer-to-peer networks. This network provides a variety of financial services that are similar to traditional banks or financial intermediaries.
You can read on for a detailed explanation of how DeFi loans work and what it means to Finance.
How does DeFi lending work?
The DeFi platform allows traders to offer their cryptocurrency to be used for loan purposes. This allows for transparent, straightforward and uninterupted access to any asset from anywhere in the globe.
DeFi boasts the best lending rate, and both lenders as well as borrowers benefit from it. Margin trading is also possible, which allows long-term investors the opportunity to borrow their assets and earn higher interest rates.
This Defi protocol allows users to obtain loans at lower interest rates. It is possible to exchange fiat for cryptocurrency and lend the money on decentralized exchanges.
Defi Lending Platforms
When utilizing DeFi protocols like Aave, users interested in becoming “lenders” need to transfer their funds into what is known as a “money market” using a smart contract, after which the tokens become available for borrowing to other users.
By mortgaging cryptocurrency holdings, crypto finance allows investors to obtain cash and crypto assets. When using crypto lending, the lender retains title to all assets. Crypto provided as collateral is not transferable during the loan period.
The process is relatively simple and is described below:
- To earn interest, users lend crypto, often stablecoins to lending platforms to make their money.
- The borrower contacts the lending platform and requests a loan.
- To insure the loan, the borrower must warrant crypto. Once the loan has been accepted, the crypto platform will attach the collateral. To receive the collateral, the borrower must first repay the full amount.
- To maintain the collateral’s value over the value of the loans, the platform can liquidate the users’ loan into stablecoins if their collateral drops below a particular range.
Here are the top DeFi loan platforms.
Aave
Aave, an Ethereum-based open-source DeFi lending protocol was launched in 2020. It allows users to lend assets and earn interest on assets that they submit to it. DeFi allows lenders to build assets and receive tokens in return.
Algorithmically Aave adjusts the interest rates on crypto-assets according to the protocol’s demand and supply. You may earn more interest by depositing in fund accounts than you do from borrowing.
Aave has an estimated value of $18.44B. There have been several audits and testing conducted by third parties. Aave was awarded a 95 security score.
Maker
Maker, an Ethereum-based DeFi lending platform, issues the DAI token. This stablecoin is pegged to a $1. Maker also has MKR, a secondary token. Holders of tokens can vote on governance issues, including the mending of stability fees and other risk parameters.
Maker is open to anyone creating a vault to deposit collaterals like USDC, ETC, or other assets and reproduce DAI against the collateral.
Maker, with a value totaling $15.74B and security scores of 85, is considered one of the most secure platforms.
Compound
Compound, an Ethereum-based algorithmic DeFi lending app that uses a money market approach in the cryptocurrency space, is an Ethereum-based application. This allows you to place assets in community liquidity pools, and then trade and accumulate interest. There is no fixed term for the loan.
Compound’s total value is $15.74B. The platform has been rated 95 by security experts.
Alchemix
Alchemix, a loan-based Ethereum DeFi platform uses a unique method where loans are automatically paid back over time. In exchange for depositing DAI into a smart contract, a token is given to the user, representing the deposit’s potential future yield.
Access to all DeFi platforms is possible through your CoinStatsWallet. This wallet acts as your gateway to DeFi and allows you to buy, sell, trade, buy, lend, earn, track, and track all of your digital assets in one place.
DeFi Lending Rates
DeFi lending offers a significant benefit over traditional financial loans in that it allows its users to make high-interest earnings, with earnings between 5% and 15% APR (Annual percentage Yield).
Earning protocol fees
For activities such as the borrowing, lending and swapping of assets, DeFi protocol charges modest fees. In exchange for liquidity, several DeFi projects share a portion the fees that they make.
CoinStats provides data on the fees and interest rates for various protocols. Aave and Compound are today the top earners based upon Ethereum.
Petroleum Fees
Developers levy transactional or gas fees to enable transactions to be processed on Ethereum Blockchain, where most of DeFi transactions take place.
While the Ethereum transaction fee was equal to $0.45 at June 2020, there were an additional 2,686% in September. The new cost is now $12.54.
The last quarter of the year saw a decrease in fees because there was slower activity. However, on January 4, 2021 $17.56 was the average transaction gas cost, which was the highest recorded price so far.
Every transaction must attract a minimum 21,000 Gas. This is what the Ethereum yellow paper requires. Most platforms adopt this limit as their default limit. A user must set a gas ‘limit’ and gas ‘used.’ The interrelation of these two will regulate the price – the higher your gas limit is, the faster your transactions will be processed.
Source: ycharts.com
DeFi Lending Risks
It’s right to assume that DeFi lending offers one of the most reliable and attractive approaches to earning passive income, with significantly higher interest rates compared to traditional financial institutions. There are risks, however, just like any other financial institution.
These are the top three risks that everyone must be aware of before they lend crypto assets.
You risk “impermanent loss” when investing your assets in a liquidity pool.
When assets that an investor has locked in a liquidity pool experience a price change after they have been deposited, this is called impermanent loss. This is a different from holding assets in crypto wallets by the liquidity provider.
Popular liquidity pools use the Automated Market Maker system to reduce risk of loss. The DeFi pool must maintain two tokens in their assets ratio. An ETH/LINK pool might have a ratio of 1 to 50, for example. Anyone wishing liquidity would need to deposit Link and Ether in that same ratio.
Flash loans are a new generation of loans that don’t require collateral. Smart contracts are used to reduce the risk of unsecured loans with flash loans.
The borrower must repay all of the loan within the transaction. The repayments are usually made in a matter of minutes. If the borrower is not able to repay the loan, the transaction will be canceled.
The DeFi Rug-pulls scam is an innovative type of decentralized finance exit scheme.
DeFi platforms don’t have regulations like traditional financial systems, and the users’ trust in the platforms they choose to trade their assets on is usually breached through Rug-pulls.
Developers create new crypto currencies and pair them with Ether. Afterwards, a liquidity pool is formed. The pool promises a high interest return and encourages people to invest their assets. A lot of people are now interested in the new token.
Back doors that are intentionally coded into the token’s smart contract are then used to mint millions of new coins and then sell the popular cryptocurrency.
This acts drains the most valuable cryptocurrency from the pool and leaves behind millions of useless coins. The developers also disappear without a trace. Famous Rug-pull incidents include the time Chief Nomi of SushiSwap, founder in 2020, liquidated his SUSHI tokens following accumulating collateral that was more than one billion dollars.
DeFi Loan Threats:
You can still investigate potential risks and avoid getting scammed by financial institutions, despite the rise in fraudsters.
These are the main points we have summarized for you.
Step #1: Verify the team’s integrity on other projects.
Step #2: Carefully read through the project’s whitepaper.
Step #3: Check if a third party has audited the project’s code.
Step 4: Pay attention to red flags like unrealistic interest rates and excessive promotions.
Conclusion
DeFi lending is a genuinely captivating technology with the capacity of reshaping the world’s financial system. The DeFi lending platform aims at decentralizing traditional financial services, such as investing, loans, borrowing and trading.
With its first ever global financial system created by its own population, Decentralized financial lending opened new avenues for financial possibility.