What are DeFi Loans?

To understand decentralized finance loans, let’s start with what “DeFi” lending means. These lending platforms focus on providing trustless crypto loans. DeFi achieves this by creating open-source, non-custodial tools for the ecosystem. This approach significantly impacts the lending and loaning process, as there is no need for a credit check, personal data, or even a bank account. This act makes it possible for everyone to participate in this decentralized system.

One of the essential features of DeFi lending is its heavy reliance on crypto collateral. Unlike traditional finance, DeFi market participants remain anonymous. While the value of crypto assets may fluctuate, just holding them in hardware wallets won’t generate any interest. This is where DeFi loans come in. With DeFi loans, users can lend their crypto to someone else and earn interest on the loan collateral value, making it a viable option for earning returns on idle assets.

Key Takeaways

• Lending platforms are important to the Decentralized Finance (DeFi) world. However, these platforms are mainly used for crypto asset speculation instead of providing loans to the real economy.
• Since borrowers are anonymous, DeFi lending requires borrowers to put up more collateral than necessary, creating market instability. Moreover, the need for collateral limits access to credit for those who don’t have assets to put up, which goes against the goal of financial inclusion.
• To integrate DeFi lending into the real economy, the system needs to tokenize real assets and gather more information about borrowers. However, this may result in more centralization of the platform.
• DeFi loans are currently one of the fastest-growing areas in the blockchain and cryptocurrency industry. Asset holders can lend their assets and earn interest. At the same time, borrowers must provide collateral more significant than the loan value to protect against price fluctuations.

Understanding DeFi

Borrowing has been a significant driver of economic growth since the beginning of civilization. Time is the most valuable resource. Historically, safe borrowing and lending have been limited to traditional financial institutions such as banks. People turn to traditional banks for loans, mortgages, and credit while utilizing them as intermediaries to invest their money. This has been the norm for decades, and it places a lot of trust in these institutions to act in the best interest of their clients.

One aspect of how Decentralized finance works, or DeFi, doesn’t aim to dismantle these existing systems. Instead, it seeks to imitate and enhance traditional finance. DeFi is an ecosystem of blockchain-based applications providing various financial services similar to those provided by conventional banks and insurance brokers. The primary difference is that these decentralized applications, called dApps, operate autonomously without any third parties involved.

Each dApp is powered by smart contracts. This computer program performs a specific function automatically when certain predefined conditions are met. Smart contracts serve as the foundation for DeFi due to their self-executing nature. Ethereum has been the leading lending platform for DeFi, with most DeFi applications developed on top of it.

One example of a classic financial service made available by these peer-to-peer dApps is DeFi borrowing. You can lock up your money or supply liquidity across various DeFi networks and get monthly interest payments, much like investing cash into a storage account to earn interest payments.

Read More: What is a Decentralized Automonmous Organization (DAO)?

How Does DeFi Lending Work?

In the world of DeFi protocols, lending has become accessible to everyone. As a lender, you can lend your digital assets to others and earn interest on the loans given. This is made possible through lending pools, which allow multiple investors to pool their assets together and collectively lend them out. Two crucial components make decentralized lending protocols possible:

• First, the blockchain’s immutability ensures no one can alter the crypto loans record. Each transaction is timestamped, chained chronologically, and cryptographically secured across hundreds or thousands of network nodes, making it virtually impossible to manipulate a transaction.
• Second, a smart contract establishes the loan terms, such as the interest rate, the number of loaned assets, and the contract’s duration. Once installed, the terms cannot be modified by anyone. If an investor wishes to make changes, they must complete the previous contract and submit a new one. Combining a blockchain and a smart contract enables peer-to-peer lending without traditional banks, where the lending and borrowing parties remain anonymous.

In decentralized finance, lending and borrowing involve a few simple steps. First, the lender deposits their cryptocurrency into a smart contract, a liquidity pool. Borrowers who wish to take out a loan can access this pool of funds under the conditions specified by the smart contract.

These conditions include the loan amount, annual percentage rate, collateral type, and loan liquidation threshold. Lenders supply money to earn interest, while customers pay interest when they use the money.

This is the interaction between DeFi and the financiers. Although each trade is a loan or investment, the way the parties interact is specific to decentralized finance.

How DeFi Borrowing Works

DeFi borrowing allows individuals to obtain loans without needing a traditional financial system like a bank. The process involves depositing collateral value, usually cryptocurrency, into a smart contract on DeFi lending platforms. The borrower can then withdraw a certain amount of cryptocurrency, typically up to a percentage of the value of their collateral, as a loan.

The smart contract governs the loan, which automatically liquidates the collateral if the borrower defaults on the loan. The platform’s algorithm sets interest rates for DeFi loans, which are often lower than those of traditional lending loans. This allows borrowers to access credit quickly and efficiently while allowing lenders to earn passive income on their cryptocurrency holdings.

Read More: What is Counterpart Risk in Crypto?

What Kind of Benefits Does DeFI Lending Provide its Users

DeFi lending promises to bring numerous benefits to users, including:

Consistent Lending Decisions:

Credit policies and rules provide consistency in lending decisions. This eliminates variations in how underwriters evaluate borrower attributes and structure crypto loans and deals.

Analytics for Process Improvement and Profitability:

Analytics helps borrowers, and lenders optimize the digital lending process. Monitoring loan applications over time can help lenders predict seasonal demands and allocate proper resources. Analytics also provides insights into demographics, credit tiers, loan sources, etc.

Transparency:

As financial instruments, every transaction on the public blockchain is broadcasted and verified by every user, ensuring transparency and verified access to data.

Permissionless:

DeFi lending allows open, permissionless access to anyone with a crypto wallet, regardless of location or funds available.

Faster Loan Origination:

DeFi loans are processed quickly, and the loan amount is available instantly upon loan approval. DeFi lending platforms use cloud services to quickly identify fraud and other lending risks, making the loan origination and lending protocols process more efficient than the traditional financial industry.

How Risky is DeFi Lending?

DeFi lending is not without its risks, while there are a lot of benefits to lending, here are some of the risks associated with it.

Impermanent Loss

When you provide liquidity to a DeFi pool, you expose yourself to the risk of impermanent loss. Impermanent loss is a loss in dollar terms caused by the change in the price of the assets you have deposited in the pool. This change happens due to the Automated Market Maker (AMM) system used by DeFi liquidity pools.

DeFi pools maintain a fixed ratio of assets in the pool, meaning that if crypto holders want to provide liquidity, you must deposit both assets in that ratio. However, the pool’s asset prices may differ from the market value due to the changing demand for each investment in the pool.

To align the pool’s asset prices with the market’s value, arbitrage traders buy the undervalued asset and sell the overvalued asset, which causes a change in the asset ratio in the pool. The pool then automatically adjusts the asset prices to encourage traders to rebalance the pool, resulting in a potential loss for liquidity providers.

Flash Loan Attacks

Flash loans are a type of uncollateralized lending exclusive to DeFi lending protocols. The traditional financial instruments model has two types of loans: unsecured loans, which are for smaller amounts of money and do not require a collateral asset, and secured loans, which are larger and require collateral, such as property, a car loan, or an investment. Centralized finance, or banks, assess clients’ credibility throughout the loan process using tools such as credit scores and reports.

Flash loans are straightforward. As a borrower, you can receive substantial crypto assets without providing collateral. However, you must repay the entire loan amount within the same transaction, typically within seconds. Flash loan attacks occur when malicious actors use these loans to borrow large sums of money, manipulate the market, or exploit vulnerable DeFi protocols for personal gain. This happened to Euler Finance in March 2023 with a flash loan attack resulting in over $195 million in losses.

DeFi Rug Pulls

Rug pulls are a scam where DeFi developers introduce a new token to a borrowing platform, pair it with a popular cryptocurrency like Ether or Tether, and establish a liquidity pool. They publicize the token and lure investors into depositing funds into the pool by offering unrealistically high returns.

When the pool accumulates a substantial amount of the popular cryptocurrency, the developers exploit secret codes deliberately added to the token’s smart contract to generate millions of new coins in the money market, which they sell for the popular cryptocurrency. This depletes the popular cryptocurrency from the pool and produces countless worthless coins. The founders then vanish without leaving any clues behind.

Read More: What is a Crypto Rug Pull?

Over-Collateralization Vs. Under-Collateralization

In DeFi loans, collateral is a crucial element. In traditional lending, you would need to put down some kind of security deposit to get a loan from the bank. The deposit is a guarantee that the financial intermediaries can seize if you default on the loan.

However, the DeFi lending protocols model differs because lenders have limited options to screen borrowers. Cryptographic digital signatures maintain the anonymity of borrowers and lenders. Lenders are unable to access data such as credit scores or income statements. Therefore, DeFi platforms rely on collateral to align the incentives of those lending and borrowing.

Over-Collateralization of DeFi Loans

DeFi borrowing requires users to deposit cryptocurrency collateral worth more than the loan itself, usually at least 1.5–3 times more. The smart contract managing the loan keeps the collateral until the loan is fully repaid. Over-collateralization is common in lending pools as most parties possess significant crypto assets.

Suppose you are wondering why people would give up control of more cryptocurrency to obtain a smaller amount in return. In that case, this is because, for some, it’s a way to avoid paying capital gains taxes on their existing crypto assets. Others believe their crypto assets will increase in value over the long term and prefer to use them as collateral instead of spending them.

The value of the collateral users get back will be appreciated through the market and from borrowing and repaying the loan. Finally, some borrowers take out loans to obtain funds for leverage in various trading positions.

Under-Collateralization of DeFi Loans

In the DeFi market, having too much collateral has become the norm. This means that a borrower’s creditworthiness is no longer a major factor because they have already provided more than enough collateral. The challenge is lending to those who need more assets to over-collateralize.

The goal is to make the lending protocol more accessible while still upholding the values of decentralization. The market is exploring various solutions to solve this problem. Some ideas involve establishing creditworthiness through blockchain-based methods. In contrast, others propose using off-chain information or assets to determine a borrower’s eligibility for a loan.

Read More: What is a Blockchain?

Flash Loans in DeFi

Flash loans have emerged as a solution to the under-collateralization problem in DeFi. These loans require specialized knowledge and operate on a different time scale than traditional lending market loans, which occur in seconds or minutes. Suppose the loan is not repaid within the allotted time frame.

The smart contract cancels it and returns everything to its previous state. Flash loans are primarily used for collateral swaps, interest rate swaps, and arbitrage opportunities. A loan is obtained to buy cryptocurrency on one exchange and then sold on another for a higher price.

Flash loans are not expected to become widespread due to the high expertise required to utilize them properly. They are also vulnerable to hackers. As a result, other under-collateralized loan options will need to mature before flash loans become a more mainstream option for DeFi lending.

What are Popular DeFi Lending and Borrowing Protocols?

DeFi lending has given rise to many innovative platforms that are revolutionizing the world of financial services. Here are some of the top DeFi lending providers you can find today.

Maker

Maker is a specialized DeFi financing network that exclusively permits DAI token borrowing. A stablecoin linked to the US dollar is called DAI. Anybody may open a vault using Maker, secure some assets like ETH or BAT, and then produce DAI as a loan against that asset.

With governance fees, which serve as the network’s interest rates, users may share in operating profits. Users can borrow DAI up to 66% of the total value of their assets. The vault is subjected to a 13% charge and liquidation to put it into default if its rate drops below the set rate. At a 3% discount, liquidated assets are sold in the open market.

Aave

Users can engage in the unregulated liquidity exchange platform Aave as funders or lenders. Depositors are essential for generating market liquidity and passive income from their holdings. Customers can obtain loans in under or over-collateralized ways. The Aave algorithm modifies interest rates according to supply and demand. The interest rate increases as a user retains more tokens.

Compound

Users may put cryptocurrencies into Compound, receive interest on their deposits, and borrow other cryptocurrencies as collateral thanks to its algorithmic and independent money market protocol. The platform’s administration and storage of funds are automated via smart contracts.

Users may connect to Compound and receive interest using Web 3.0 wallets like Metamask. Anyone with a crypto wallet and internet access can freely communicate because it is a decentralized network system. In addition to native tokens, a cryptocurrency known as stablecoins are a type of cryptocurrency and a digital alternative to FIAT money.

Read More: APR Vs. APY in Crypto

What to Expect from DeFi in the Future

DeFi lending has experienced impressive growth in recent years. Despite the challenges that may arise in 2023, there are still great opportunities ahead. Many DeFi-based projects are gaining traction as more investors pour money into cutting-edge financial technologies.

The use of flash loans is also on the rise and is expected to become even more popular soon.  However, the DeFi system is still experimental and has its fair share of issues, particularly regarding scalability and security of DeFi lending platforms.

Despite these challenges, we remain optimistic that the future of DeFi lending is bright. One potential solution to the scalability issue of DeFi lending protocols is Ethereum 2.0, which has the potential to improve the network’s scalability through a process known as “Sharding.” Sharding in cryptocurrency involves dividing the database into more manageable pieces for users to use.

As DeFi lending offers financial freedom and user-friendly systems, the latest technological advancements will continue to revolutionize how individuals and organizations share information and interact with financial options.

Final Thoughts About What DeFi Loans are

DeFi lending is a game-changer for credit access, offering a level playing field like never before. Access to lending dApps on public blockchains is open to anyone with a non-custodial wallet. The process is easy, requiring only a collateral deposit via the wallet. The same applies to being a lender, as one can become a mini-bank, earning interest on their deposited funds.

But caution is needed to guard against flash loan smart contract exploits, which can drain liquidity pools and endanger the protocol. Despite this, DeFi lending has proven its flexibility and robustness, providing a credible alternative to traditional banking. Therefore, occasional short-term hiccups are expected in the few years since DeFi’s inception.