Understanding DeFi Lending

Lending stands out as one of the pinnacle applications of blockchain and crypto. But it's not just a claim...

It's also the 2nd biggest DeFi narrative in terms of Total Value Locked (TVL)!

Let’s break down this concept ELI5.

(Explain Like I’m 5)

We’ll cover:

  1. Lending in TradFi vs DeFi

  2. How DeFi Lending Platforms Work

  3. Key Elements to Monitor

  4. Case Study

  5. 7 Risks to Consider

  6. 4 Core Benefits

Let’s goo.

1. Lending in TradFi vs DeFi

Picture this:

🌐 Traditional Finance (TradFi):

Want a loan? Prepare for paperwork – tons of it!

After laying bare your personal and financial details, there's still a risk of rejection.

Even with approval, you could be waiting anywhere from 15-45 days to see the money.

🌍 Decentralized Finance (DeFi):

Simply deposit a guarantee on a platform.

And voila! You can borrow the money you want. Instantly.

2. How DeFi Lending Platforms work

Lenders: supply funds and earn interest.

Borrowers: access loans by paying interest.

No middlemen needed thanks to blockchain, smart contracts*, and oracles**.

*smart contract: self-executing contract with the terms of the agreement directly written into lines of code.

**oracle: bridge that connects real-world information (like asset prices) to the blockchain so smart contracts can use it.

Just as banks need assurance that you’ll be financially able to repay your loan, DeFi lending platforms need a guarantee (called collateral) to ensure you won't vanish with borrowed funds.

After you deposit collateral on a platform, it'll let you know the total value you can borrow.

Here's an example:

Imagine holding 1 ETH valued at $1,600.

You're bullish about its future.

But you need $500 immediately.

Rather than parting with your precious ETH...

You can deposit it on a lending platform, and borrow $500 against it.

As simple as that!

3. Key Elements to Monitor

Now that you understand the basics of DeFi lending, here’s 4 key elements you should know:

1) Liquidation:

  • The process of repaying a loan on behalf of the borrower in risky situation.

2) Health factor:

  • The indicator of your loan’s safety. The higher the safer.

3) Max LTV: (Loan-To-Value):

  • The maximum value that can be borrowed.

4) Liquidation Threshold:

  • The percentage at which a loan is defined as risky.

5) Collateral:

  • Assets deposit to guarantee a loan.

4. Case Study

You deposit it as collateral on a lending platform.

On this platform you know that:

  • ETH max-LTV: 75%

  • ETH LT: 85%

Given this information you know that:

  • you're eligible to borrow up to 75% of your collateral's value ($1,200).

  • you risk liquidation if your loan > 85% of your collateral's value ($1500).

You decide to borrow $900 in USDC.

D+1 ETH price drops to $1,000.

Suddenly, your borrowed $900 becomes 90% of your collateral's value.

Without prompt repayment or adding more collateral, you're on the brink of liquidation.

To avoid liquidation, you could keep track of your health factor and adjust your position before it gets too close to 1.

5. Risk Assessment

The previous case study showed us some risks related to DeFi lending.

But there’s more to it.

Here’s 6 major risks to be aware of when it comes to DeFi lending:

1) Smart Contract Vulnerabilities:

  • If there's a bug or vulnerability in the smart contract code, it could be exploited, leading to a loss of funds.

2) Volatility:

  • As cryptos are volatiles, borrowers may face liquidation* if the collateral's value drops significantly. Same thing could happen if the asset’s value borrowed rises rapidly.

3) Interest Rate Fluctuations:

  • Variable interest rates can change rapidly based on market demand, which can affect both lenders' profits and borrowers' costs.

4) Liquidity Risks:

  • In times of market stress, there might not be enough liquidity on the platform, making it hard for borrowers & lenders to withdraw funds.

5) Blockchain Network Risks:

  • Depending on the blockchain the platform operates on, there might be risks related to the network's security, scalability, or potential forks.

6) Oracle Vulnerability:

  • External data sources could be compromised and provide false, manipulated, or outdated data to smart contracts, undermining crypto lending outcomes.

6. Benefits of DeFi Lending

Now that you understand how DeFi lending works and its risks, let’s finish on a positive note with its 4 core benefits:

Instant Transactions: Processes faster than in TradFi, allowing users to take out loans in a matter of minutes.

Global Accessibility: Anyone with an internet connection can access these platforms, regardless of geographic location or local banking infrastructure.

Permissionlessness: Anyone can take out loans. No discrimination on the religion, origin, sexual/political orientation… can occur. DeFi lending fosters inclusivity.

High Yield Potential: DeFi lending platforms often offer more competitive interest rates than traditional financial institutions. And sometimes, you can even get paid to borrow money 👀.

That’s a wrap!

I hope you now have a better understanding of the basics of DeFi lending.

Note that not all platforms work this way. We covered the most basic and popular DeFi lending platform mechanism taking AAVE as an example (the leader of this narrative with over $4B TVL).

If you need DeFi content for your project, let’s discuss:

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