Introduction
Borrowing and lending money has always been a significant financial service, providing individuals an access to funds that they can use for different purposes. However, in traditional banking, to qualify for such services, numerous requirements are needed, which creates a barrier to a large population, especially the unbanked.
But, the rise of DeFi lending has revolutionized the way we think about these services. Through this new financial system, lending and borrowing has never been easier and more accessible. It has given users the ability to engage in such services without the need for intermediaries.
So, how does it exactly work? That's what we'll thoroughly discuss in this guide along with the benefits and risks that it comes with.
Understanding DeFi Lending
DeFi lending functions similarly with traditional lending, however, this refers to a process of lending or borrowing digital assets, particularly cryptocurrencies on decentralized platforms which mainly uses the blockchain technology and smart contracts - the tools responsible for totally eliminating the need for human intervention or intermediaries to execute the process. Thus, DeFi lending does not only promote ease of access as it also highlights inclusivity, giving a large population an opportunity, specifically the unbanked, to take advantage of such services which weren't possible before. In addition, users who participate in DeFi also maintain control over their funds while earning interest as a lender and securing a loan as a borrower.
Furthermore, unlike traditional banks which rely on credit scores and personal information to approve loans, DeFi lending pools are very much accessible, universally. There's no need for credit checks, regardless if you're borrowing or lending funds, all you need is an internet connection and a crypto holdings for a collateral and that's pretty much it aside from understanding how it works which we will be discussing next.
How DeFi Lending Works
Okay, DeFi lending is accessible and more inclusive but how does it actually work? While the process may be complex, especially for beginners. But, as you learn the basics, it's much easier than what you will experience in traditional finance. Here's a brief and easy to understand process in a DeFi lending system:
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First, users will deposit their crypto assets into lending pools or liquidity pools in a specific period of time.
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Then, these pools will serve as the facilitator, they will lend the deposited assets to borrowers.
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In return, lenders will earn interest on their funds, making it a potential source of passive income.
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The interest will vary depending on the market's current annual percentage rate as well as distributed tokens in the platform which determines the value of the original loan plus the interest earned. This is a key factor to consider when deciding Should You Be Using DeFi?
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Once the loan matures, the amount that was lent along with the interest will automatically be transferred in the depositor's account.
Over-collateralization vs. Under-collateralization
One of the key concepts in the world of DeFi lending is over-collateralization. This pertains to the process where for users to borrow crypto, they must secure a collateral with a value that's much higher than the loan itself which is often 1.5 or up to 3 times higher than the loan amount. The main reason for this is the market's volatility where the value of cryptos can drastically decrease or increase. Thus, to minimize the risks on the lender's end, there should be an allowance in the collateral before securing a loan.
Aside from being able to secure a loan, over-collateralization also has strategic advantages for borrowers. Particularly allowing borrowers to prefer using their crypto holdings as a collateral instead of selling it which completely loses their ownership. By doing so, they can preserve their long-term investments while also being able to use their borrowed funds for immediate liquidity. This is a key concept in decentralized finance.
On the other hand, there's under-collateralization, a much difficult to find concept in DeFi lending as not many platforms offer this service. Furthermore, this pertains to a type of loan where borrowers are not required to over-collateralize their assets, as the name implies. However, some proposals may include using blockchain-based credit scores or incorporating off-chain data to evaluate the trustworthiness and credibility of a borrower, which is kind of similar to traditional lending.
Flash Loans - A Special DeFi Feature
This is another type of loan that offers a unique feature in the DeFi lending ecosystem. This allows the borrower to take out a loan and repay it within the same blockchain, occurring in a fast-paced manner. Flash loans are typically used for specific purposes such as arbitrage and collateral swaps. However, these may require expertise and typically come with higher risks. If ever the loan will not be repaid within the set time frame, it will be reserved, as if the transaction never happened.
True enough, flash loans really offer interesting and rewarding income opportunities for advanced crypto users, capitalizing on the market loopholes. However, it's definitely not ideal for casual investors without knowledge about the process as it can get too complex along the way and is highly vulnerable to hacking. If you're interested in learning more, check out our Comprehensive Guide on DeFi.
Conclusion
Overall, DeFi lending is really reshaping how people can lend and borrow assets for the better. With the integration of new technologies such as blockchain technology and smart contracts, lending has never been more accessible and transparent, even offering higher yields compared to traditional finance. However, it's not without flaws and users should be aware of the risks and vulnerabilities it's associated with.
