Borrowing has been a critical pillar of the financial system for generations. Not only do customers borrow from banks, but banks borrow from each other to meet their reserve requirements. They say money makes the world go round, but ultimately it’s debt that provides the propulsion.
Although the concept of a loan is simple to understand, lending is a relatively recent innovation in the world of cryptocurrency, enabling individuals to obtain capital or earn interest on their digital asset holdings. Blockchain-based lending/borrowing protocols have proliferated at a rapid rate in recent years, flying under the flag of open or decentralized finance (DeFi), and more than any other primitive, they have been responsible for billions of dollars of value flooding into the market. So, how does crypto lending work? And where does the industry go from here?
Decentralized Lending: Cutting Out the Middleman
In recent years, institutional lenders such as Genesis, BitGo, and Galaxy, as well as their DeFi counterparts Compound, Aave, and Maker, have sucked a tremendous amount of liquidity into the market. For the purposes of this article, we’re going to consider the lending market in the context of DeFi.
Just as banks do with fiat currencies, DeFi lending protocols pay interest on savers’ cryptocurrency deposits from the margin generated through loan issuance. Lending protocols can be utilized by individuals or businesses, with smart contracts automating the process through a decentralized network rather than an intermediary.
In other words, the protocols – which are generally Ethereum-based – provide the technology to facilitate borrowing and lending, rather than taking custody of clients’ assets and manually managing the operation. Ostensibly, users interact in a peer-to-peer fashion.
While some familiarity with crypto is an advantage, these trustless protocols are committed to lowering the barriers to entry and enticing more players into the market. In theory, it’s not a hard sell: investors stand to earn significantly higher yields in crypto lending than in legacy markets.
At present, DeFi lending protocols generate over $650 million in annual interest; borrowers, meanwhile, have taken out almost $7.5 billion in loans. While these numbers are minuscule when compared to the regular credit market, they are growing all the time. And as the price of assets like bitcoin and ethereum rise, more people are likely to put their savings to good use by locking them up to earn yield.
The DeFi Lending Market
As mentioned, the major players in DeFi lending are Compound, Aave, and Maker. According to DefiPulse, Compound rules over 50% of the lending market and over 60% of borrowing.
When users supply cryptocurrency to Compound, they receive cTokens in exchange, ERC20 tokens that can be redeemed for their underlying asset at any time. Like many of its competitors, Compound relies on an algorithm to assign interest rates to its supported cryptocurrencies including DAI, ETH, WBTC, USDC, USDT, UNI, ZRX, BAT, SAI, and REP. Anyone with an Ethereum wallet can interact with Compound, depositing crypto to immediately start earning interest or borrowing against collateral.
Where borrowing is concerned, all loans are overcollateralized. Meaning if you want to borrow, say, DAI, you’ll need to over-collateralize the loan amount with another digital asset such as WBTC.
According to Messari’s Ryan Selkis, Compound’s rival Maker “may have been the critical building block that laid the foundation for DeFi’s credit markets, stablecoin markets, and ultimately, 2020’s DeFi bull run.” Within the Maker ecosystem, users can acquire loans denominated in the platform’s dollar-pegged Dai stablecoin. To ensure system stability, users are required to maintain a margin of at least 150% overcollateralization, relative to the quantity of Dai that they have minted.
Lendefi is another popular lending protocol. Uniquely, it provides access to undercollateralized loans – meaning users can acquire loan values that would otherwise be unattainable. Lendefi makes this possible by tapping into decentralized liquidity pools such as Uniswap, which facilitate peer-to-peer trade. The protocol is controlled by the community via a Decentralized Autonomous Organization (DAO), enabling active participation of token-holders in the direction of the platform as a whole.
Naturally, the terms of crypto lending depend on which asset you are depositing or borrowing, as well as the time period specified for repayment. The aforementioned DefiPulse provides a snapshot of current rates, though LoanScan features a wider range of providers, from Nexo and BlockFi to Yearn, dYdX and Curve. Generally speaking, interest rates start from around 0.03% and rise in some cases to over 50% APY.
DeFi Lending Risks
If DeFi lending sounds like a land of milk and honey, think again. While these protocols are, in the main, safe and secure, hackers have also been able to exploit flaws and steal user funds. Last year, for example, the Value DeFi platform lost $8 million worth of DAI stablecoins in a complex attack. Another DeFi platform Akropolis lost $2 million in a similar attack.
The truth is, funds locked in DeFi protocols are only as secure as the code underlying the protocols themselves. Which is to say nothing of the risks related to market movements, which can cause users to become undercollateralized – meaning they have to add more funds to avoid liquidation.
Ultimately, it’s still very early days for DeFi lending. While these protocols give borrowers and lenders a gilt-edged opportunity to bypass banks, it pays to do your research and place your trust in a reputable, secure platform that offers peace of mind. Providing you do your due diligence, crypto lending can be an extremely rewarding way to unlock liquidity and generate a passive income from your assets.
Disclaimer: This material is not sponsored by any organization mentioned in the article.
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