How Does DeFi Lending Work?

chirag August 16, 2022
How Does DeFi Lending Work

The rise of DeFi has strengthened the prospects of blockchain implementation in the development of financial apps. DeFi or decentralized finance, has recently gained prominent attention as it has garnered massive amounts of capital for various businesses.

You will be surprised to know that almost $20.46 billion is locked in DeFi protocols, proving that the popularity of the DeFi applications has escalated to a considerable margin. This has influenced the growth of DeFi lending. DeFi lendings are one of the upsurging parts of the cryptocurrency ecosystem. These types of loans are now allowing crypto holders to lend their assets and earn lucrative interests.

In simple words, DeFi lending is all about offering crypto loans on a decentralized platform. Among all the decentralized applications (Dapps), DeFi has the highest lending growth rate globally. It is one of the prominent contributors utilized for locking crypto assets.

How does DeFi Lending Work?

How does DeFi Lending Work?

By now, you know that DeFi lending aims to offer a transparent, permissionless, and open-source financial service environment.

Now let’s move on to discuss the commonly asked question, “how does DeFi lending work”.

DeFi lending, or decentralized finance lending, is quite similar to the traditional lending service offered by the banks, except that it is offered by the P2P decentralized applications (DApps). The DeFi lending platforms help people borrow and lend funds which allow the crypto holders to earn a substantial income.

The DeFi lending process is simple. It focuses on offering crypto loans with a trustless approach. This means that the users can easily lock their crypto assets on the DeFi lending platform without worrying about intermediaries. The borrowers can directly opt for loans from the decentralized platform with the help of P2P lending.

In addition to it, the DeFi lending protocol helps lenders to earn interest on crypto assets. As compared to the conventional loan processing system of the banks, DeFi lending enables individuals to become a lender just like a bank. An individual can easily lend their assets to others and accrue interest on that loan. Just like the loan offices in traditional banks, DeFi lending mainly relies on the lending pools where the users can add their assets to the lending pool and ensure quick distribution among borrowers through smart contracts.

With various mechanisms for the allocation of interest to investors, it is crucial for lenders to identify the type of interest. Borrowers also need to do their part of research on the lending pools as each pool has a different borrowing approach.

How is DeFi Lending Different from Traditional Lending?

How is DeFi Lending Different from Traditional Lending?

The traditional financial system provides borrowing, lending, margin trading, and spot trading. The DeFi ecosystem, however, has adapted and can offer similar financial services.

One of the crucial differences between DeFi and traditional lending is that conventional banking involves a time-consuming process along with continuous checks on a customer’s status. DeFi, on the other hand, grants loans quicker as long as the individual meets all the collateral requirements.

The smart contracts take care of the entire reviewing process, making it easier for the borrower and the lender. DeFi lending typically offers better returns when compared to the traditional lending markets.

Bonus Read- What is DeFi Insurance? Identifying Business Opportunities and Use Cases

What Kind of Benefits does DeFi Lending Provide to its Users?

DeFi lending mainly works by engaging the participants to contribute funds by depositing them at interest. These interest rates are more lucrative than the rates offered by traditional banks. Other than that, there are multiple benefits of DeFi lending as compared to the traditional lending system. These include:

Benefits does DeFi Lending Provide

Accountability

Accountability is one of the top benefits of DeFi lending. Blockchain is a public ledger that can offer on-demand records of all the DeFi loans along with the policies and rules that granted that loan. The public distributed ledger mainly serves as proof of all the financial transactions when a particular DeFi loan gets granted.

Lending Analytics

Having a complete digital process for lending mainly helps in the assessment and monitoring of the borrowing and lending market. Lending analytics is another major benefit of the DeFi lending process. The lending analytics can be utilized for optimizing funds. It also allows various DeFi lending platforms to gain insights on loan sources that can help them improve the performance of the loan.

Speed

DeFi loans are processed quickly, and the lent amount is available instantly once the loan is approved. DeFi loans are processed faster because the DeFi lending platforms are powered by cloud services that help identify any fraud and other DeFi lending risks.

Immutability and Transparency

Blockchain can be easily verified by any user present in the network. DeFi lending ensures transparency as the decentralized nature of the blockchain mainly ensures that all the transactions are genuine.

Permissionless

Decentralized lending offers permissionless and open access to anyone with a DeFi crypto loan wallet. One can easily access the DeFi applications built on blockchain networks regardless of the presence of their fund or geographical location.

Interoperability and Programmability

By utilizing the interconnected software stack, one can ensure that the DeFi lending protocols complement and integrate with each other. Also, smart contracts are highly programmable and enable the development of financial instruments and digital assets.

Asset Management

Crypto wallets and DeFi lending protocols like Metamask, Gnosis Safe, and Argent enable the users to be the sole custodians of their crypto assets. It also allows the users to interact with the decentralized applications securely and avail the services of selling, buying, earning interest on investments, and transferring crypto.

Savings

DeFi lending platform has now come up with innovative ways of savings management. By plugging into different lending platforms, users can maximize their earnings and avail the services of interest-bearing accounts.

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Constraints in Decentralized Lending

Several prominent discussions about decentralized finance largely focus on the benefits of DeFi lending. However, it is equally vital to highlight the cons for analyzing its potential effectively. Here is the list of critical setbacks that you can encounter soon after adopting DeFi lending:

Uncertainty

If there is any instability while hosting a blockchain in a DeFi lending, then the process can automatically inherit instability directly from the host blockchain. Currently, the Ethereum blockchain is undergoing various changes. For example, the mistakes committed during the PoW consensus transition to the new Ethereum 2.0 POS system could lead to risk.

Scalability

DeFi lending can encounter difficulties maintaining scalability for the host blockchain from various aspects. For example, the DeFi transactions require more time for confirmation. At the same time, the DeFi protocol transactions could become a bit expensive during the congestion period. Overall this affects the entire scalability.

Shared Responsibility

Amongst all the disadvantages, the shared responsibility factor completely works the opposite for the users. If there is an error from your end, the DeFi projects do not take responsibility. All they do is take away the intermediaries, so only the user becomes responsible for their assets and funds. Therefore, the DeFi lending process requires tools that can prevent the possibility of human errors or mistakes.

Liquidity

Liquidity is another crucial factor in blockchain protocols and DeFi-based lendings. As of June 2022, the total value locked in the DeFi project was around 77.29 billion US dollars. For a better understanding the current TVL of DeFi market, refer to the infographic below:

current TVL of DeFi market

The market value of DeFi has declined to less than 80 billion US dollars since June 2022. These significant changes caused the DeFi market to get highly impacted by the crash for Terra (LUNA) and its stablecoin Terra USD (UST) on May 22, when coins such as USDD lost their peg to the US dollar.

Other than that, a declining crypto market has also impacted the DeFi lending process. Therefore, it is evident that the DeFi market is not as trustable or big as the traditional financial systems. So, it can be difficult to put your trust in a sector with liquidity concerns.

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Top DeFi Lending Platforms

DeFi lending platforms offer loans to businesses or the public with no intermediaries. DeFi lending protocols enable people to earn interest on cryptocurrency and supply stablecoins. Here is the list of top DeFi lending platforms:

Top DeFi Lending Platforms

Compound

Compound is a kind of autonomous interest DeFi lending rates protocol utilized for open financial applications. Users can directly earn a passive income by depositing the cryptocurrency through borrowing and interest crypto.

Compound grants the holders the right to vote on certain decisions like technically upgrading the platform and adding new assets. As a crypto lender, you will get a CToken as per the amount they supplied to the liquidity pool. A CToken is specific to those digital assets provided in the liquidity pool. These tokens will earn interest based on the liquidity pool’s respective interest rate. The top 3 markets on Compound are USDC, ETH, and DAI.

Aave

Aave is yet another popular DeFi lending platform that was launched in 2020. It is non-custodial and an open source liquidity protocol. Aave allows its users to deposit crypto in the liquidity pool soon after which they will receive the same amount of ATokens.

The interest rates are adjusted as per the current demand and supply in a given liquidity pool with an embedded algorithm. The interest defi lending rates increase with more AToken holders. Read this blog to know more about asset tokenization in blockchain.

YouHodler

YouHodler is another hybrid platform that provides crypto-backed lending with stablecoins and fiat loans. The mission of YouHodler is to help people to stop passive holding (buy-and-hold strategy) and utilize crypto assets completely. Based out of Switzerland, YouHodler, also offers an exchange policy.

The exchange supports fiat, crypto, and stablecoins. YouHodler offers better interest rates when compared to the other lending platforms. The current interest rate is 12.3% which is better than other lending platforms like crypto.com, Binance, Celsius Network, and BlockFi.

Bonus Read- How Much Does it Cost to Develop a Cryptocurrency Exchange App like Coinbase?

Uniswap

Built on the Ethereum network, Uniswap is a decentralized crypto exchange. One of the biggest advantages of this platform is that the users can get complete control of their funds with the exchange of smart contracts.

Also, new coins can be easily listed on the exchange with the help of a factory smart contract. Users can easily swap their ERC-20 tokens leveraging Uniswap.

MakerDAO

MakerDAO is a decentralized lending platform from which you can only borrow DAI tokens. DAI is a kind of stablecoin that is pegged to the US dollar. You can easily borrow DAI through Maker while offering collaterals like BAT or ETH.

The users of MakerDAO are encouraged to take part in the operational earnings, which are only the interest rates for the network. Users can borrow DAI up to 66% of the collateral value.

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What is the Future of DeFi Lending?

DeFi lending has seen stellar growth in the last few years. Although the year 2023 is likely to bring new challenges, there are also excellent opportunities. Several projects based on DeFi are gaining momentum as more investors invest in top-notch financial technologies. The popularity of flash loans is also increasing, and in the upcoming days, it is expected to upsurge.

However, recently few problems with flash loans have been noticed, as it is more prone to suspicious and fraudulent activities. Despite all the technological advantages, DeFi loan processing is still lagging regarding financial breaches and security issues.

In the future, it is expected to be upgraded and improved.

The financial system currently is experimental, new, and has its problems, especially with scalability and security. But we still believe that the best is yet to come. The DeFi industry might find a solution in Ethereum 2.0. Ethereum 2.0 has the possibility of improving the scalability of the network through a concept known as Sharding.

Sharding is a way of dividing the database into more feasible pieces for the customers to use. How organizations and individuals share information, interact, and utilize financial options will continue to be revolutionized by the latest technological advancements as DeFi lending continues to supply its customers with financial freedom and user-friendly systems.

Avail the unique decentralized finance development services of a blockchain development company like Appinevntiv, and get prepared to experience the change in your business. Learn more about the DeFi ecosystem and how does DeFi lending work from our experts today!

FAQs

Q. Are there any risks associated with DeFi lending?

A. With a clear impression of how beneficial DeFi lending could be, let’s move on to discuss the DeFi lending risks. DeFi lending is not as straightforward as you think it to be. First, you need to check if the DeFi lending protocols are safe and have met all the levels of security. If not, then it becomes easier for the hackers to exploit the vulnerabilities in the DeFi protocols by stealing the assets of the users.

Here are the 3 types of DeFi lending risks:

1. DeFi rug pulls: Imagine yourself standing on a rug, and suddenly someone pulls it with full force. The DeFi rug pulls are something very similar to this. Although DeFi looks quite promising, there is no set of clear regulations for the ecosystem.

Thus, the investors must place their trust in the platforms on which they are willing to purchase tokens or lend their assets. However, the investors can also fall prey to cyber breaches in the shape of rug pull schemes.

2. Impermanent loss: The volatile nature of the crypto tokens is the main reason behind the impermanent loss. The investors are required to lock their assets in the liquidity pools for the DeFi lending process, and the change in the asset price after depositing them in the pool thereby creates an impermanent loss.

The impermanent loss might also emerge from the fact that the DeFi pools considerably depend on the arbitrage traders for aligning the token prices in the pool with the existing market value.

3. Flash loan attacks: Flash loans are a new type of loan in the DeFi space that does not require any kind of collateral. This is also known as DeFi loan without collateral. You can find two distinct types of DeFi crypto loan in the form of secured and unsecured loans in the conventional banking space. Secured loans are larger and require specific collateral like property, investment, car, or any other big asset. Banks then evaluate the client’s credibility by utilizing tools like credit reports and scores in the entire loan process.

On the other hand, unsecured loans mainly involve the disbursement of a smaller amount of money which means DeFi loan without collateral. Flash loans can offer a formidable risk in DeFi lending as malicious attacks can happen. Few agents can also utilize flash loans to exploit the defending protocols for their own personal interests.

Q. What are some of the DeFi lending protocols?

A. The DeFi lending protocols are also known as the DeFi lending platforms that allow the users to secure a DeFi loan. The loan can be in the form of any type of cryptocurrency on the platform. For securing a DeFi loan, the borrower must deposit a collateral type that is usually around the loan value of 150% to 200%.

Q. How can one get a loan from DeFi?

A. Anyone can apply for a DeFi loan and get it. The borrower needs to use a DeFi lending platform like Compound or Aave. The borrower will also be required to deposit collateral which is yet another type of cryptocurrency, in order to secure a DeFi crypto loan.

Q. Is Ethereum a type of DeFi coin?

A. DeFi is currently making its way into different types of complex financial transactions. It is mainly powered by the decentralized apps known as “dapps,” or other programs called “protocols.” Together, dapps and protocols handle the main transactions in the two main cryptocurrencies, Ethereum (ETH) and Bitcoin (BTC).

Q. What is a DeFi dApp?

A. DeFi is the short form of the term ‘Decentralized Finance’ which mainly refers to the financial smart contract, DApps (decentralized applications), and all other types of financial protocols built on blockchain. Typically, there are 5 main categories of DeFi, which include lending and borrowing, derivatives, dex (decentralized exchange), assets, and payments.

Q. What is the key difference between DeFi and NFT?

A. The key difference between DeFi and NFT is that DeFi is about the internet-based financial system, whereas NFT is about individual digital assets.

THE AUTHOR
chirag
Blockchain Evangelist
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