Defi Lending Explained
TLDR; DeFi Lending, a new type of lending that is completely reshaping the Finance industry, is non-custodial, doesn’t require users to trust third-parties; it is permissionless and trustless thanks to the power of Smart Contracts.
Removing the middleman
We are in the midst of a Financial Revolution brought about by the rapid deployment of Decentralized Finance protocols that aim to decentralize and eliminate our collective reliance on middlemen. Decentralized Finance provides tools based on blockchain technology that allow users to execute transactions trustlessly and without the need of a custodian. The notion of a financial ecosystem that is trustless, open, and permissionless is extremely powerful.
DeFi Lending allows depositors to make the digital assets they own available to borrowers via decentralized Lending Platforms, in return for interest on their deposits. Borrowers are willing to pay interest on funds advanced in exchange for having them available immediately. All of this is done in a trustless and permissionless fashion thanks to Smart Contracts designed to automate the management and storage of capital.
Lending & borrowing available to anyone
DeFI Lending allows everyone, even the unbanked and the displaced, who might not have the required identification at hand in order to open a traditional bank account, to become a lender, to participate, regardless of their geographical location and financial status. Privacy is enabled by default: all you need is a cryptocurrency wallet. The ramifications are enormous: no credit checks, personal data or references are required to partake in DeFi Lending.
When users deposit funds on lending platforms such as Aave, Compound and Maker (three of the most popular lending platforms today), they receive tokens (atokens or ctokens, for example) which are “representations” of the assets they deposited. On Compound, users will receive cETH, which they can redeem at any time for ETH. This is fairly fascinating. Thanks to Decentralized Finance’s characteristic interoperability, these tokens (perhaps it would be better to call them “tokenized deposit positions”), which accrue interest, can be used in other protocols. The ctokens distributed by the Compound protocol can be used as collateral, for example.
Interest calculation & over-collateralized loans
The interest that depositors receive and what borrowers have to pay is calculated by using the ratio that exists between the supplied and borrowed tokens in a specific market.
In order to obtain a loan, a user needs to provide collateral in Fiat or in Crypto. If Tom wants to borrow 1000$ in DAI, for example, he will need to deposit collateral on a lending platform’s smart contract. DeFi loans are typically over-collateralized.
If loans are over collateralized, why do users even use DeFi lending services in the first place? A user might be willing to put down this amount of collateral because he does not want to liquidate a cryptocurrency position, but needs urgent access to funds for Margin Trading (to increase leverage) or for an emergency situation. DeFi Lending allows users to retain possession of their digital assets and have access to funds to fulfill other needs and take care of unforeseen expenses.