How DeFi Lending Works in the World of Crypto

Decentralized finance (DeFi) has emerged as an innovative alternative digital finance spectrum to traditional finance. Unlike traditional finance, DeFi eliminates the need for intermediaries, allowing users to directly engage in lending, borrowing, trading, and more.

Despite being too tech-heavy, DeFi has reached billions of valuations in less than a decade since its inception. According to DefiLlama data, there is over $57 billion of total value locked (TVL) in different protocols. This amount once peaked at nearly $180 billion in November 2021.

Contents

This article delves into the innovative realm of DeFi lending—a core component of DeFi that facilitates peer-to-peer loans without the traditional banking system’s complexities.

What is DeFi?

DeFi is a cryptocurrency-based financial spectrum that works on the ideology of decentralization. It is permissionless, transparent, and open for all, regardless of any physical location.

The foundation of DeFi is based on cryptocurrencies and blockchain technology. It includes a variety of financial applications such as staking, lending, borrowing, trading, and more.

What is DeFi Lending?

DeFi lending is the practice of peer-to-peer crypto asset loans, which works in a trustless and automated manner. It allows a user to borrow and access funds by putting other assets as collateral. Users can utilize the borrowed funds however they want.

The lending varies on several aspects, such as collateral type, asset usability, or market dynamics. Some DeFi protocols let users borrow funds exceeding the collateral valuation – called under-collateralized loans – while some protocols allow a limited amount of funds to ensure that the loans are secured, which are called over-collateralized loans.

Additionally, borrowers also have to pay a predefined interest on loans. Those interest rates are primarily measured in annual percentage yield (APY) and annual percentage returns (APR).

As it’s distinct, DeFi is accessible from all around the world, and anyone can lend or borrow without any geographical restrictions. The lending and borrowing form a decentralized money market where participants can transfer funds to each other without the involvement of banks or fiat currencies.

Theoretically, DeFi lending functions on the principles of trustless, peer-to-peer, and an open network where transactions are executed without any intermediaries.

Elements of DeFi Lending

All the below-noted elements together form an ecosystem that facilitates lending and borrowing in decentralized finance.

Liquidity: Liquidity is the most significant element in decentralized finance. It refers to the current availability of assets that can be used instantly. In the DeFi space, liquidity plays a vital role by enabling a variety of applications to be built and run.

Smart Contracts: Blockchain-based smart contracts are the digital strategies to functionalize liquidity in the DeFi ecosystem. These contracts have different sets of methods and instructions that allow them to lend, borrow, or utilize crypto assets.

Lending Pools: DeFi lending pools are essentially smart contracts where users provide liquidity. Users can borrow funds from these pools while paying fixed or dynamic fees associated with them. These fees may vary depending on the popularity of the asset.

How DeFi Lending Differs From Traditional Lending

In traditional finance, borrowers may have to go through lengthy paperwork and, in some cases, even regularly visit branches of money lenders. Moreover, as traditional lending works under regulatory compliances, borrowers have to submit income proofs and other privacy-preserving documents to lenders.

DeFi lending, on the other hand, is completely hassle-free and does not require any kind of information from borrowers. The inherited characteristics of blockchain, such as transparency, immutability, and high-end security, make DeFi lending far more secure than traditional lending.

DeFi Loans

DeFi Lending and borrowing are functionalized using crypto loans that different lending platforms offer.

Following are the types of loans in DeFi;

1. Over-collateralized Loans

When a user deposits collateral to a DeFi lending protocol, it allows them to borrow up to 80% of assets. For example, when a user deposits $1,000 of ETH, they will be able to borrow up to $800 in loan.

These loans are called over-collateralized loans as the protocol has efficient collateral that is used as security against lent amounts. DeFi lending protocols can use this collateral to liquidate the user’s position if they fail to pay back.

2. Under-collateralized Loans

Under-collateralized loans are the opposite of over-collateralized loans, where users can borrow higher amounts in loans from the DeFi lending protocol. These kinds of loans are usually confident crypto loans that lending platforms provide, assuring borrowers will be able to pay them back.

3. Flash Loans

Flashloans are non-collateral crypto loans offered by some DeFi lending platforms. These loans are processed and paid back in a single blockchain transaction. The lending protocol will only allow to borrow funds if it sees the user is paying back all amounts with interest in the same transaction. It is a novel financial instrument in DeFi.

Benefits of DeFi Lending

By elevating the convenient way of decentralized financing, DeFi lending offers several inventive advantages to users. Some of them are as follows;

Permissionless: Borrowers or lenders do not have to go through any permission in order to participate in DeFi lending. The nature of decentralization makes DeFi lending universally open with no geographic restrictions at all.

Foolproof: DeFi lending works on smart contracts that provide completely foolproof executions of all transactions and numerical outcomes. The mismatching of even one decimal either ceases the transaction or produces a non-identical output than what is desired.

Programmability: Users can experiment with DeFi lending using the smart contract functionality. The code for such contracts could include hundreds of transactions and conditions under which a certain transfer could take place.

Peer-to-peer/No Intermediary: DeFi lending does not require any middleman to approve or verify the lending criteria. The whole process is peer-to-peer, and no one can interfere when a borrower processes to access funds from DeFi lending pools.

Vast Liquidity: Borrowers can access vast liquidity in decentralized finance, which usually remains unused most of the time. The DeFi lending industry has reached billions of dollars in valuation, which sufficiently addresses the need for liquidity. Even a single user could borrow millions of dollars as long as collateral conditions are met.

Popular DeFi Lending Platforms

DeFi lending platforms or protocols are the places where decentralized lending and borrowing are accessible. These platforms are deployed on blockchain networks as a set of smart contracts. Below are some popular DeFi lending platforms;

Aave: As the pioneer of DeFi, Aave is one of the earliest decentralized lending and borrowing protocols. It was previously known as ETHLand when it launched in 2017. Aave is currently the most popular DeFi lending protocol with a TVL of over $10 billion, and it is deployed on 8 different blockchain networks, including Ethereum, Polygon, and others.

Compound: Compound is also a leading DeFi protocol that enables borrowing and lending for a variety of crypto assets. It primarily operates on Ethereum, and it has a TVL of nearly $2.4 billion.

MakerDAO: While Aave and Compound focus on different crypto assets, MakerDAO functions to lend the native stablecoin DAI against other assets such as ETH. The value of DAI is pegged to the US dollar and used as a hedge against volatility in the crypto market. Borrowers can secure over-collateralized DAI loans from the MakerDAO against their collateral.

Venus Protocol: Venus is the most popular DeFi lending protocol built on BNBChain. It enables lending and borrowing of assets such as BUSD, BNB, USDT, and BTCB on BNBchain, which was launched by the team behind the Binance crypto exchange.

Also Read : Top 8 Best Crypto Exchanges For 2024

Conclusion:

The decentralized finance ecosystem is continuously expanding, and it is expected to reclaim hundreds of billions in TVL as the cryptocurrency market reaches new heights. DeFi lending and borrowing have happened to be the most innovative and attractive applications in the field of finance in recent times.

Being relatively new, the DeFi lending industry has gained remarkable growth, and it still has vast opportunities to grow further. It has the potential to completely reshape the finance industry and enable an extensive financial ecosystem that is trustless, robust, and secure.

FAQs

Q1. What is DeFi lending and borrowing?

Ans: DeFi lending and borrowing is the activity of offering or making crypto loans in a decentralized manner.

Q2. What are the DeFi lending platforms?

Ans: Aave, Compound, MakerDAO, Uniswap, Curve, etc. are examples of lending platforms.

Q3. What is Flashloans?

Ans: Flashloan is a quick crypto loan offered by several DeFi protocols under the condition that the borrowed amount is paid back within the same blockchain transaction.