What is DeFi lending?
DeFi lending is a way of earning interest on your crypto assets by lending them to other DeFi users who need to borrow them. People borrow crypto assets for various reasons, including covering real-world expenses, enhancing exposure to a particular crypto asset, engaging in trading and speculation, and avoiding capital gains tax on their crypto holdings. Anyone can become a lender or a liquidity provider by depositing their crypto assets into a smart contract that acts as a pool of funds. Borrowers deposit collateral to withdraw funds from these liquidity pools.
A smart contract is like a digital agreement that lives on a blockchain, which is a secure and transparent ledger. Think of it as a computer program that automatically enforces certain rules and conditions without the need for a middleman.
Imagine you want to borrow some crypto asset, and someone else wants to lend that asset. A smart contract will hold your collateral (a valuable item you provide as security) and keep track of the lender’s crypto asset. The smart contract keeps everything safe and ensures that when you repay the borrowed crypto asset, you'll get your collateral back.
The interest rate for DeFi loans depends on the supply and demand of each asset. For example, if many people want to borrow DAI, but few people are lending it, the interest rate for DAI loans will go up. The interest rate is calculated by the platform’s algorithm and automatically updated at regular intervals. Interest payments are usually made in the same crypto asset that was lent and compounded continuously.
DeFi lending is different from traditional lending because it does not involve any intermediaries or centralized institutions. Instead, it is a form of peer-to-peer (P2P) lending where individuals can lend and borrow directly from each other. Most DeFi loans are over-collateralized, which means that borrowers have to deposit more value in collateral than the amount they want to borrow. For example, if a borrower wants to borrow 100 DAI from Aave, they have to deposit 150 USD worth of ETH as collateral. This reduces the credit risk for lenders and ensures that they can recover their funds in case of default. One thing to keep in mind is the collateral requirements may vary depending on the quality of the asset. For example, USDC may have a collateral ratio requirement of 90% while WBTC’s might be 80% because it is more volatile and less liquid than USDC.
Where does the yield come from in DeFi lending?
Lending allows borrowers to get a loan against digital assets, and liquidity providers earn interest during the maturity of the loan.
DeFi lenders can earn income from two sources:
- Borrowing fees: These are the fees that borrowers pay to access the loans from the pool. For example, if a borrower takes out a loan of 100 DAI from Aave (a DeFi lending platform), they will pay a borrowing fee to the pool, which will be distributed among the lenders who supplied DAI. Some platforms may also charge a one-time fee when a loan is opened or closed.
- Token rewards: These are the rewards that lenders receive for participating in a platform’s ecosystem. For example, if a lender supplies DAI to Compound, they will receive COMP tokens as an incentive. These are commonly referred to as governance tokens. Governance tokens can have value for various reasons, such as giving holders the right to vote on platform decisions, earning potential revenues, or influencing the direction of a project's development.
Is DeFi lending safe?
Most loans in DeFi today are over-collateralized, so even in the event of default, lenders are able to recoup their losses through liquidations of the underlying collateral.
Liquidations in DeFi refer to the process of selling a borrower’s collateral to repay a loan when the value of the collateral falls below a certain threshold. In DeFi lending platforms, this serves as the primary risk management mechanism to ensure that lenders can recover their funds in case borrowers are unable to repay their loans.
In some instances, your deposited assets may become illiquid (unable to withdraw) if there are too many users borrowing your supplied asset.
As a borrower, the over-collateralization of loans potentially increases your risk as your collateral can drop in value and be liquidated, resulting in your investments selling at a lower price than you may have hoped. However, in most cases, only a portion of your collateral will be liquidated and you still retain ownership of the borrowed assets.
What are the advantages of DeFi lending?
DeFi lending has several advantages over traditional lending:
- Transparency: All DeFi transactions are recorded on the blockchain, which is a public and immutable ledger. This means anyone can verify that the platform is operating correctly, track where their funds are at all times, and confirm that their funds are secure.
- Accessibility: Anyone with an internet connection and a crypto wallet can participate in DeFi lending, regardless of their location or credit history. There are no barriers to entry or discrimination based on identity or geography.
- Lower fees: DeFi lending platforms charge lower fees than traditional lending institutions because they do not have to pay for staff, offices, or regulatory compliance. Some lending platforms even offer zero-interest loans!
- More flexibility: DeFi lending platforms offer various options for lending and borrowing, such as different loan terms, collateral types, and interest rates. Users can choose the option that suits their needs and preferences.
Where can I start lending in DeFi?
If you want to start lending your assets to earn yield, you can check out some of the top platforms in this space:
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