Lesson #2: Lending

The second step to decentralizing finance is, of course, on-chain lending. There are now lending systems on the blockchain, which are often built on smart contracts. However, these lending systems can’t send repo men to your house if you don’t pay up, or know your credit score and revenue, and cannot therefore evaluate your reliability as a borrower like a traditional bank would.

So how does on-chain lending work?

On-chain borrowing usually requires you to provide a collateral equivalent to between 1,25 and 3 times the borrowed amount. The system then functions like futures liquidations on an exchange: if the value of your collateral ever approaches a point where it will cause a loss to the protocol, it will be automatically liquidated, in order to recover the borrowed amount and associated interests.

As for lending, nothing too complicated. You deposit money, and the protocol lends it to other users who are then charged interest when they pay back their loan. You may use the deposited funds as collateral for a loan of your own while they earn interest.

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Potential use cases for lending/borrowing

But, what’s the point of borrowing if you already have the money? Especially if you have to provide up to 3 times the borrowed amount as collateral!

Well, this is one example if you wanted to long an asset:

Let’s say I have 10 ETH. I am holding these ETH because I think they will increase by 28% in value, however in a shorter term I would like to enter a long on LINK which I think will increase by 20%. It would not be profitable for me to swap my ETH for LINK, since ETH will perform better! Therefore I will borrow the equivalent of 5 ETH in USDT, providing my 10 ETH as collateral, and buy LINK with it. Once my LINK is sold and I have made a profit, I can pay back the USDT I borrowed and, let’s say, 5% interest, recover my 10 ETH, and pocket the difference.

As for a short :

The general idea is the same, except I will borrow LINK this time, sell it for USDT, buy it back cheaper after it dumps and once again pay back the loan and pocket the difference.

There is just one question left: where does the protocol find all this money to lend out?

‍ Once again, these funds are often provided by LPs. This means anyone can provide these protocols with the necessary liquidity, in exchange for a yield from the interests charged on loans. This practice is also part of "Yield Farming".

This is not always the case however, as some procotols like Maker, Vesta or Abracadabra mint their own stablecoin to lend out.

Examples:

  • Maker: Over-collateralized stablecoin lending protocol on Ethereum

  • Aave: Multi-chain lending protocol

  • Compound: Lending protocol on Ethereum

  • TraderJoe: Lending protocol on Avalanche C-Chain

  • Yeti: Over-collateralized stablecoin lending protocol on Avalanche C-Chain

Version française disponible sur Muchcoin

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