DeFi lending protocols allow people to borrow crypto, just like the way you can go to a bank and take out a loan.
First, let’s explain how this works in traditional finance (TradFi):
In the TradFi world, I go to a bank to get a loan. The bank has cash to lend me because all of us keep our money at the bank, which we are incentivized to do because of the services they provide (like keeping track of our money, giving us debit cards to spend money, etc.) and because they pay us interest to keep it there.
The bank is allowed to lend our money to borrowers, and make money in the process.
Let’s look at a simple example.
Let’s say Adam has $10,000 at the bank earning a 2% savings rate. At the same time, the bank lends $10,000 to Betty but at a 5% borrowing rate. The math is:
The bank owes Adam $200 per year (2% * $10,000)
Betty owes the bank $500 per year (5% * $10,000)
The bank profits $300 per year ($500 - $200), making a 3% spread
Here’s how lending works in the world of DeFi.
DeFi lending protocols cut out the middleman (the bank) entirely. Instead of depositing money at a bank, we can invest our crypto into a lending protocol and potentially earn higher returns on our holdings. This is similar to how a savings account works, but with DeFi, the interest you earn comes directly from the fees paid by borrowers, potentially offering a more attractive interest rate. Instead of a bank pocketing interest from a loan, you earn yield.
Let’s adjust our example to work for DeFi.
Instead of Adam depositing his $10,000 at the bank, he invests it in a DeFi lending pool featuring USDC, a stable asset that is pegged to the value of 1 USD. The lending protocol makes his 10,000 USDC available to Betty to borrow. Betty happens to also be charged 5% interest for her loan here, generating 500 USDC in interest over a year for Adam. Instead of Adam receiving $200 from his TradFi savings account, he receives 500 USDC (worth $500) from the DeFi protocol. So:
Betty is charged $500 per year by the protocol (5% * $10,000)
The protocol pays Adam $500 per year (5% * $10,000)
That covers lending. Next, we get to know a job you might be less familiar with — market making.