How Does DeFi Lending Work?
Decentralized finance (DeFi for short) has become a major part of the cryptocurrency landscape, allowing users to access financial services without relying on traditional banking or other centralized organizations.
DeFi lending is one of this space's most popular and rapidly growing components, enabling people to lend their digital assets directly to borrowers in exchange for interest payments. In this guide, we’ll take a look at how DeFi lending works and what you need to know before getting started.
Please note, none of the content in this post is financial advice but is instead educational material with fictional examples.
How the Wealthy Stay Wealthy
Buy Borrow Die is a financial strategy that involves purchasing assets with borrowed money and then holding onto them until death. This strategy has gained popularity due to the low-interest rates that have made borrowing money more accessible and affordable.
Many proponents of Buy Borrow Die argue that it is a way to create wealth by using leverage and taking advantage of inflation.
However, critics warn that this strategy can be risky and could lead to debt and financial instability. Despite the controversy surrounding it, Buy Borrow Die remains an intriguing concept in the financial world that continues to be debated and studied.
How Does It Apply to Crypto?
Selling crypto for profit, yield farming, and several other scenarios create taxable events in most countries. One of the best ways to avoid these occurrences is to deploy a Buy Borrow Die strategy to take profits.
For example, you bought BTC in 2012. You purchased 100 BTC back then at $12 a token. It was a little pricey, but hey…you never know what will happen, right?
Even in the middle of the nastiest bear market in crypto history, that 100 BTC is worth $2.7 million at current pricing. If you were to sell it, you would face a monstrous bill from your local tax authority.
Borrowing could be the right play if you want some funds. You can move your BTC to a lending protocol, borrow against it at a relatively safe LTV ratio, and do some different things.
You could withdraw all of it and spend it however you choose. Keep in mind you still have a loan to pay back. So a wise strategy could be something like this:
You borrow at 25% LTV, which would be $675,000.
Take half and go have a nice time.
Take the other half and farm stablecoins.
You will probably earn around 5% interest and can use that to pay back your loan at your convenience. DeFi lending doesn’t work the same as TradFi.
There are no monthly payments. And there is no reporting to the credit bureaus if you don’t pay for a month.
The best part? You keep your 100 BTC.
What is DeFi Lending?
Defi lending is a form of lending that allows users to lend and borrow cryptocurrencies without the need for intermediaries such as banks or financial institutions.
It offers a more efficient, transparent, and cost-effective alternative to conventional lending methods by eliminating intermediaries.
Using smart contracts and blockchain technology, users can participate in defi lending by depositing their crypto assets into a pool, which are then lent out to borrowers.
In return, lenders earn interest on their deposited assets, while borrowers get access to funds at significantly lower interest rates compared to traditional lending methods. Defi lending is a game-changing innovation set to revolutionize how people access credit and invest their assets.
Benefits of DeFi Lending
DeFi lending offers a number of benefits for both borrowers and lenders. The main advantage for borrowers is access to funds at lower interest rates than traditional credit products. Some protocols may even pay you to borrow using their platform, which will likely be awarded to you in their token.
This makes it easier and cheaper for them to get the money they need without excessive fees or waiting around for approval processes.
For lenders, lending allows them to earn passive income and diversify their portfolios with low-risk assets. It also enables them to access global markets, as they can lend to borrowers across the world while still earning interest on their investments.
Finally, DeFi lending gives users greater control over their funds, as all transactions are done using smart contracts and blockchain technology. This ensures that users have complete autonomy over their funds and can access them at any time.
Drawbacks of DeFi Lending
Despite the numerous benefits, there are some risks associated with this product.
For example, since it is a new technology, there is no guarantee that all platforms or protocols will be reliable and secure. This means that users should always do their research and make sure to only use reputable projects before getting started.
Aave is the most popular DeFi lending platform and has been forked several times. Some of these forks weren’t successful, and some of them were outright rugs.
Additionally, since the cryptocurrency market is known for its volatility, it can be difficult to accurately predict how much money a lender will make from their investments due to fluctuating prices.
DeFi lending is also subject to smart contract risks, as errors can occur when code is deployed to the blockchain. As such, users should always be sure to double-check their contracts and never sign anything without fully understanding the implications.
But for most users, the biggest drawback is the dreaded liquidation.
Liquidations Explained
Extreme volatility can lead to liquidation. It's a word that can strike fear into the hearts of investors, but understanding what it means and how it works can give you a sense of control and confidence in your investments.
Essentially, liquidation occurs when the value of a collateral asset falls so low that it can no longer support the amount of borrowed funds against it.
When this happens, the system automatically liquidates the collateral, selling it off to repay the loan and avoid losses for the lender. It's a mechanism that helps keep the defi ecosystem stable and trustworthy and something every crypto investor should understand. So if you want to dive deeper into the world of crypto and defi, take some time to learn about liquidations and how they work.
While not every protocol uses Aave’s system, it is the most popular, and most forks out there use it. Here are some examples straight from their docs:
“Example 1 Bob deposits 10 ETH and borrows 5 ETH worth of DAI. If Bob’s Health Factor drops below 1 his loan will be eligible for liquidation. A liquidator can repay up to 50% of a single borrowed amount = 2.5 ETH worth of DAI. In return, the liquidator can claim a single collateral which is ETH (5% bonus). The liquidator claims 2.5 + 0.125 ETH for repaying 2.5 ETH worth of DAI.
Example 2 Bob deposits 5 ETH and 4 ETH worth of YFI, and borrows 5 ETH worth of DAI If Bob’s Health Factor drops below 1 his loan will be eligible for liquidation. A liquidator can repay up to 50% of a single borrowed amount = 2.5 ETH worth of DAI. In return, the liquidator can claim a single collateral, as the liquidation bonus is higher for YFI (15%) than ETH (5%) the liquidator chooses to claim YFI. The liquidator claims 2.5 + 0.375 ETH worth of YFI for repaying 2.5 ETH worth of DAI.”
But can we break it down into ELI 5 terminology? We can try, but keep in mind this will be incredibly oversimplified.
You have one ETH. You borrow against it at a 70% LTV ratio (Don’t ever do this, it’s just an example). Let’s say the ETH has a current valuation of $3,000. News hits that something catastrophic is about to happen or is happening. The FUD hits the market, and ETH dives all the way down to $1,500.
Well, you borrowed more than $2,000 in stablecoins against your ETH. The protocol is now in trouble and on the verge of being stuck with bad debt, so they offer up your position to a liquidator, who agrees to pay back a portion in exchange for a fee.
Do you lose everything? No. At least, not all the time. The best case scenario is you’ll get back some of your funds and have a nice new haircut to show off to your degen friends.
How Does DeFi Lending Work?
At its core, DeFi lending works by connecting borrowers and lenders with a decentralized platform. Borrowers must deposit their collateral assets into the platform as security before taking out loans.
Once this is done, lenders can assess loan requests and decide which ones they want to fund based on the amount of risk involved.
Once approved, the loan is recorded on the blockchain and distributed to those who funded it.
The borrower can then access their funds while repaying their loan over time with interest.
Meanwhile, lenders will receive the repaid principal plus any interest earned in exchange for providing the loan capital. All of this happens fully decentralized, allowing users to gain access to funds quickly and securely.
Types of DeFi Lending Platforms
DeFi lending platforms come in all shapes and sizes. Some popular platforms, such as Compound and AAVE, offer users a wide range of services, including margin trading, stablecoins, decentralized exchanges (DEX), cryptocurrency-backed loans, and more.
Other platforms like MakerDAO specialize in offering crypto-collateralized loans. Each protocol has its own set of features, so it’s essential to do your research before deciding which one best fits your needs.
Conclusion
DeFi lending is a powerful and revolutionary way to access credit, invest assets and earn passive income. It offers easy access to funds at competitive rates while allowing lenders to diversify their portfolios in global markets.
With its smart contract technology, DeFi lending also gives users complete autonomy over their funds. However, users need to understand the risks associated with this new technology before getting started by researching platforms and double-checking contracts.
Whether you’re a borrower or lender looking for an alternative financial solution, DeFi Lending could be just what you need!