DeFi was born from the belief that the traditional financial system relies too heavily on third-party institutions for transacting money. Some argue that this reliance introduces issues with systematic inefficiencies, trust, and inequalities in access to important financial tools. Built using blockchain technology, DeFi protocols aim to make financial tools available to the masses and sidestep inefficiency pitfalls by connecting people through decentralized, peer-to-peer networks.
One of the most important mechanisms of the financial world is lending and borrowing. Individuals who wish to make a large purchase (such as buying a car or a house) and don’t have the money to do so can ask a bank for a loan, agreeing to slowly pay it back over time with interest. On a larger scale, companies often need capital to invest in materials, infrastructure, and personnel to grow their business at a rapid pace. These entities can also borrow money from a bank and repay their loans over time with revenue made possible by those loaned funds.
Decentralized lending and borrowing tools allow anyone to make this critical banking function simple, transparent, and accessible to crypto users across the world without the need for intermediaries.
How does it differ from the traditional banking system?
Before taking out a traditional loan, borrowers must go through a number of mandatory steps so a financial institution can determine the likelihood they will default (fail to make the required monthly payments). In other words, using traditional lending rails, you have to qualify for a loan.
First, banks check potential borrowers’ credit scores. These are based on an individual’s borrowing and payment histories, total debt currently owed, and a number of other factors. There are also forms that ask personal information such as income and current assets—like a house—that could be used as collateral. Some loans may even require another person to co-sign with a borrower.
Qualification is not a prerequisite in DeFi. Because loans are secured by smart contract automation, the process of lending and borrowing in DeFi protocols is trustless. Lenders don’t have to worry about borrowers defaulting on the loan, because the over-collateralization of loans ensures that the equivalent value of lent funds can always be recovered by the lender. In turn, borrowers don’t have to go through an approval process, have their credit history checked, or reveal their income to secure a loan.
Another difference is that interest rates for lending/borrowing in DeFi protocols are largely set by two factors:
- Supply and demand for loans – When there are more lenders than borrowers in a system (high supply environments), interest rates are pushed down to attract more borrowing. Conversely, when there are more borrowers than lenders (high demand environments), rates are increased to make lending more attractive. Although this is true within a system, it is also a factor that affects cross- market participation, driving DeFi users to patronize one platform over another. This helps ensure that DeFi lending and borrowing is a maximally efficient market. While this also works in the world of traditional loans, DeFi makes this a much more efficient phenomenon.
- Decentralized community governance – Base rates may be determined by a platform’s community governance, which can set a standard expectation and also be used to incentivize participation.
Lastly, in DeFi you can directly be the lender of your funds without a third party doing it for you. Lending pool protocols allow any crypto holder to lend their digital assets to other users. This means anyone can benefit from the opportunity to charge interest (that is, generate a passive yield) as loans are repaid by those who borrow your crypto.
How does decentralized lending and borrowing work?
Types of decentralized lending and borrowing
The lending pool model is the most common form of lending and borrowing in DeFi. Protocols that use lending pools deepen liquidity by aggregating funds from many sources for borrowers. It can therefore be conceptualized as a “peer-to-pool-to-peer” lending structure. Lenders deposit crypto into a pool of assets, where borrowers take out those same assets and agree to pay them back with interest. The interest charged for all borrowers is then divided among all lenders to generate a stable yield.
Leveraged trading is another form of borrowing. In decentralized derivatives markets, similarly to traditional finance, crypto traders can use margin to increase their exposure to cryptocurrencies with the goal of increasing their earnings. However, in DeFi, the process aims to be more efficient and fair thanks to its transparency and automation as well as the overcollateralization of funds to account for the sometimes-high volatility in price.
In a standard mortgage, a borrower’s assets (like a house, for example) are used as collateral to secure the loan. Therefore, if a borrower can no longer make payments, the bank has the right to repossess their house.
Collateral is also necessary to secure certain loans in DeFi.
Some protocols set collateralization ratios that govern how borrowers secure their loans. If a user borrows $100 of crypto at a 150% collateralization ratio, for example, they must always have $150 worth of assets or more locked up in the protocol’s smart contract—until they pay back the loan. Because these ratios require users to lock up more than the amount being borrowed, such loans are called overcollateralized.
However, overcollateralization can often be complicated by the fluctuations in values of cryptocurrencies, so most borrowers choose to secure their loans with a cushion that exceeds the stated collateralization ratio. If the value of a borrower’s collateral falls below the protocol’s threshold, their funds get liquidated, and their assets will be distributed to the platform’s lenders.
A flash loan is the process by which a user borrows and repays a loan in one block through complex computer code and interactions with smart contracts.
Before blockchain and DeFi, flash loans were not possible. These unsecured, instantaneous loans are largely used to take advantage of arbitrage opportunities when two markets price an asset differently. In between the steps of borrowing and repaying the loan, a user sends the borrowed funds through one or more additional platforms to swap assets, resulting in a quick profit.
Decentralized lending and borrowing risks
There are risks in the use of almost every financial tool. Even holding cash comes with the risk of devaluation due to inflation. It is important to be familiar with the risks associated with decentralized lending and borrowing before jumping in.
One such risk is called counterparty risk, where one party who agrees to a contract does not meet its contractual obligation. Although usually lenders’ “counterparties” are borrowers, in DeFi the users’ counterparties are actually the lending/borrowing platforms and their smart contracts.
On one hand, there is a chance that users lose their crypto because there is not adequate decentralization of a platform, allowing its owners to remove any deposited funds (also known as “rug pull”). Alternatively, exploits and hacks of smart contracts can result in the illicit siphoning of assets out of a platform and into hackers’ wallets. One such exploit is called a flash loan attack, which uses flash loans to take advantage of bugs in smart contract code.
Another major risk is impermanent loss, which occurs when a user’s assets lose value in a liquidity pool, as compared with simply holding the assets in a wallet. Impermanent loss occurs because automated market makers and arbitrageurs are constantly rebalancing assets in liquidity pools to both maintain a constant ratio and to take advantage of small variations in price. Through that process, rises in asset valuation often underperform a strategy of holding that asset outside of a pool. This loss is called “impermanent” because it is not realized until the assets are withdrawn back into a wallet.
What are some examples of decentralized lending and borrowing?
- Aave is the prototypical lending and borrowing DeFi platform. It was one of the trailblazers of the pool-based model of issuing loans built on a system of smart contracts. It offers its services on multiple chains including Ethereum, Fantom, Avalanche, Polygon, and Arbitrum.
- Compound is another example of a money market that uses pools to connect lenders and borrowers. Like Aave, some of its most actively loaned assets are ETH, wrapped bitcoin (wBTC), and stablecoins.
- MakerDAO is the issuer of DAI, a stablecoin that is pegged to the US dollar. Users can deposit their crypto into Maker Vaults to collateralize loans in DAI. As the first crypto-collateralized stablecoin, MakerDAO’s DAI changed the landscape of DeFi when it was introduced in 2017.
- dYdX and Cap.finance are derivatives markets where users can trade cryptocurrencies using margin—a specific type of borrowing—for leverage.
- Decentralized lending and borrowing takes a familiar concept from traditional finance institutions and democratizes it using the tenets of DeFi and blockchain technology.
- Because of the trustless nature of DeFi, decentralized loans do not require evaluation of credit scores or other personal information, and interest rates are set solely by market participants rather than third-party institutions.
- The most popular model for decentralized lending and borrowing is through lending pools, which connect users through aggregate collections of digital assets; borrowers are required to overcollateralize the loans they take from these pools.