In this post, based on a recent livestream, Alex Pipushev, the founder of GTON Capital, explains how lending protocols work in centralized and decentralized finance.
Lending protocols – also referred to as money markets - play a significant part in the decentralized finance (DeFi) industry, as they enable users to lend and borrow assets in an immutable, transparent and decentralized way.Conventionally, money markets were centralized structures facilitating deals between lenders and borrowers.
Borrowers are those users who approach money markets to get a short-term loan that they need, for instance, to get extra leverage in trading. Meanwhile, lenders are individuals who have assets they want to earn yield on. Borrowers are required to pay interest on the loan to the lender and a fee to the money market.
Borrowers put up other assets as collateral and, if they can't repay the loans they have taken, the lenders can sell the collateral to recover the loaned funds – a process called liquidation. However, if the loan is successfully repaid, the collateral is returned to the borrower.
Let’s consider an example of a trade on a crypto lending platform that would be concluded in centralized finance (CeFi), or CeDeFi – protocols that pretend to be centralized but their backend servers hardly used smart contracts and therefore lack transparency.
In the example, a user borrows 100 USDT - an equivalent of $100, putting up BTC as collateral. The value of the collateral has to be higher than that of the borrowed amount due to the volatile nature of crypto, which is called overcollateralization. So, the borrower has to deposit the equivalent of $150 in bitcoin as collateral. Overcollateralization needed to prevent collateral from liquidation due to price volatility. However if collateral price is falling down too much, it has to be liquidated and liquidators are getting extra fee for liquidating potentially uncollateralized loans.
As soon as the loan period ends, the borrower repays the loan, also adding interest on top of 100 USDT they originally borrowed. The lender gets back their 100 USDT plus 10 USDT in interest, of which the lending platform deducts its fee.
Upon repaying the loan, the borrower collects $150 in bitcoin, which they originally put up as collateral. Or, to be more precise, the borrower collects the exact amount in bitcoin that they put up as collateral at the time of taking the loan, and since that time, the bitcoin's value could have changed.
Meanwhile, decentralization and blockchain technology open up new opportunities for lending platforms. Unlike CeFi/CeDeFi, lending platforms in decentralized finance (DeFi) are powered by blockchain technology and run on smart contracts, which enables them to offer users several additional features.
DeFi lending protocols are immutable, decentralized, permissionless, non-custodial and composable, Alex explained, adding that overcollateralization is controlled by smart contracts.
Our next example illustrates the process of borrowing crypto on a DeFi lending platform, which is in many ways similar. However, USDC is a more popular stablecoin for DeFi lending protocols than USDT, while ETH is more often used as collateral than bitcoin.
A user borrows 100 USDC, depositing an equivalent of $150 in ETH as collateral. Upon the end of the loan period, the borrower repays 100 USDC plus interest and withdraws their ETH. The 100 USDC is repaid to the lender with a 10 USDC interest, paying a fee to the lending platform.
Meanwhile, DeFi also facilitates another approach to crypto lending, in which new stablecoins are minted when a borrower deposits coins as collateral.
A DeFi lending protocol can enable users to not only lend and borrow stablecoins, but also mint stablecoins," Alex P explained during the livestream. "That principle was used by one of the first stablecoins, the MakerDAO protocol's DAI. Originally, only ETH could be used as collateral for DAI, but now, it could be collateralized by multiple cryptocurrencies. When putting up collateral, a borrower on MakerDAO opens a collateral debt position (CDP), and stablecoins that are supposed to be borrowed are minted."
The same approach is used by GCD, the GTON ecosystem's stablecoin.You can use the protocol's native token GTON or ETH as collateral and mint GCD, a stablecoin.
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About GTON Capital
GTON Capital builds infrastructure to advance digital capital markets including GTON Network — L2 Ethereum rollup with $GCD stablecoin as a native currency, Pathway — algorithms for the pricing of governance tokens, set of mutually reinforcing DeFi protocols, DONs, and more.
By combining cutting-edge achievements of Web 3.0 technology, GTON Capital creates a more advanced and stable foundation for DeFi development.
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