- Decentralized finance presents an interesting alternative to the archaic system of finance we are trapped in.
- Platforms like Celsius and BlockFi are decentralized to a considerable extent but they work quite similar to the way banks work.
- The lender can select a coin and a smart contract of their choice, and the interest is generated according to the smart contract and the coin.
The history of lending and borrowing is as old as money itself. It is much older than the system of banking as we know it today. For quite some time in history which also considers a chunk of the present, banks have been regarded as the epicenter of finance.
With the introduction of blockchain and cryptocurrency, people started to question the relevance, control, and censorship that banks process over our finances. This has led to the development of decentralized finance, commonly abbreviated DeFi.
What Is DeFi?
As the name implies, DeFi is a system of decentralized applications that run on the blockchain to execute certain financial tasks. The entire DeFi system is built in such a way that multiple applications flawlessly interact and interlock with each other to perform all the tasks that would be expected in a world of finance.
The biggest difference between centralized and decentralized finances is the rendering of financial institutions obsolete. The financial institutions played the role of an arbitrator that is needed to establish trust in the transactions. While this can be considered an important aspect of finance, it also indirectly costs a lot of money, all of which falls on the consumer.
Decentralized finance presents an interesting alternative to the archaic system of finance we are trapped in. It aims to, as the name implies, decentralized all the operations that are required for a financial ecosystem to keep it steadily up and running. If DeFi has to replace the existing financial system, it needs to be able to at least provide all the services that today’s finance is providing.
Digressing A Bit To Talk About The Differences
It is to be remembered that everything about DeFi would deal with cryptocurrency but not everything that deals with cryptocurrency can be termed DeFi. One of the biggest examples of this Venn diagram is the cryptocurrency exchange. A cryptocurrency exchange essentially deals with cryptocurrency but is by no means a decentralized body. There are a few decentralized exchanges but a major chunk of crypto exchanges in operation today are centralized exchanges.
Lending And Borrowing In Defi
We have already seen that lending and borrowing is one of the most basic operations of the current financial system. Today, the fractional banking set up is the most prominent method used across the globe. A lender or a lending body provides funds to borrowers with the funds that they need for a regular interest rate. In most cases, these funds are facilitated by a huge financial institution like a bank, and in rare instances, by a private party on a peer to peer level. Whatever be the body/person that provides the loan amount, the modus operandi does not change.
When it comes to crypto lending, the way in which the process is executed is pretty much the same. In most cases, there are centralized financial institutions like Celsius that provide crypto loans. Platforms like Celsius and BlockFi are decentralized to a considerable extent but they work quite similar to the way banks work. These platforms take custody of the deposited assets and they loan them out to third parties like market makers. This provides the depositor a steady stream of income through returns.
Although the model looks fantastic on paper, it is quite prone to almost all the Vulnerabilities of centralized platforms like theft, insider jobs, and hacks.
DeFi protocols do away with both these disadvantages and they allow users to become lenders or borrowers. While centralized crypto platforms do pretty much the same thing, DeFi platforms do it without necessitating a hub to get the process done. This would mean that the users have complete control over the funds at all times.
DeFi protocols make use of open blockchain solutions like Ethereum. The establishment of trust and the facilitation of transactions is taken care of by smart contracts. DeFi ensures that lending and borrowing can be effected without compromising on privacy. They do not mandate handing over of private/personal data to any central authority.
How Does Lending And Borrowing Work On Defi?
To understand the way in which lending and borrowing books on DeFi, we will need to dive deeper into the concept of the money market. The money market is pretty much what the name literally means. It is a repository guarded securely by a smart contract. Users who wish to become lenders can supply their tokens to this smart contract through which it is taken to the money market.
The smart contract, in essence, acts as an automated digital intermediary. It sends the interest for the deposit in the form of tokens without needing human intervention. The interest can be redeemed at a later stage. It is to be noted that the tokens that are provided as interest are native to the platform.
When a user intends to borrow from the money market, they need to provide a guarantee in the form of crypto. The crypto fund that they provide as the guarantee should be Worth more than the loan that they intend to borrow. This is referred to as over-collateralization.
It might seem illogical to borrow funds when they already have more than what they intend to borrow. It could seem that they could sell their assets and get their money. However, there might be some users who do not intend to sell their Holdings because the price of the asset is expected to increase in the future. Borrowing can also help avoid or delay the payment of capital gains taxes on their digital tokens. Borrowed funds can also help increase the leverage on trading positions.
When it comes to the money market, there are multiple smart contracts that can facilitate the deposit of funds. The lender can select a coin and a smart contract of their choice, and the interest is generated according to the smart contract and the coin.
The interest depends on the ratio that exists between the supplied and borrowed tokens in the market. The annual percentage yield of the borrow is higher than the supply percentage yield in a particular market because of the over-collateralization.
The APY for the interest is determined for the Ethereum block and it implies that users could be provided with variable interest rates that can vary depending on the lending and borrowing demand for a particular token. There are some protocols that offer stable borrow APY and flash loans where no upfront collateral is required.
The Risks In Defi Lending And Borrowing
It is quite evident that the risks involved with DeFi are far less than what you would expect with a centralized platform. However, it is to be noted that the entire DeFi ecosystem is heavily dependent on smart contracts. Therefore, it might not be an exaggeration to say that though security and vulnerability of the DeFi depend only on the smart contract.
One of the most prominent risks involved with the smart contract is the threat of dramatically changing annual percentage yield within a short period of time. One good example of such a dramatic change would be the time of the yield farming craze in 2020. The borrow annual percentage yield on certain cryptocurrencies rose to more than 40%. Such fluctuations mandate that users keep a tab on the daily interest rates, so they do not re-pay more than what they might have initially expected. These fluctuations render the entire concept of over collateralizing illogical and not dependable in the long run.
Although the system and the interdependencies might be secure, one cannot completely discount the possibility of human errors. There might be instances of people choosing a smart contract without taking into consideration the factors like the wallets and the applicable fees. They also might miss out on the fine print with respect to the interest rate and the payment of interest.
There have also been instances of people entering the wrong wallet number and inaccurate address details. This results in funds being sent to the wrong wallet and since the entire ecosystem Operates on the blockchain, there is no way to recover and retrieve the deserved funds in case of such wrong entries.
Overall, the entire process of lending and borrowing on DeFi is simple and easy. However, the inaccuracies involved in entering information and the inconsistencies in the choice of smart contracts and coins should be avoided to make the entire endeavor profitable and dependable.
Most centralized and traditional financial institutions have certain restrictions that cap the borrowing capacity of a person. There are such factors that exist in the decentralized world of borrowing as well. They can be summed up under two major umbrellas: liquidity and collateral cofactor.
By definition, liquidity is the ease with which an asset can be converted to cash. As you can input from the definition, the most liquid asset in circulation is cash. In the context of The DeFi world, liquidity refers to the total fund pool that is available to be borrowed. In most cases, liquidity is not an issue that might govern the borrowing capacity. However, on paper, the volume of money that can be borrowed is contingent upon the volume of money that is available to be borrowed. Liquidity chips in as a factor only when a user tries to borrow a large volume of a certain token.
It does not, however, happen in most cases because of the demand for over-collateralization. If they have money to overcollateralized, that user, in themselves, our market makers!
The next factor called the “Collateral cofactor” is a combination of both quality and quantity. It is specific to a particular type of token. The collateral cool factor is the total amount of funds that can be borrowed based on the quality of the collateral provided. For example, Ethereum’s native token has a collateral factor of 75% on a leading DeFi lending platform. Therefore, if the user can deposit 100 ETH as the collateral, they can borrow 75 ETH.
The borrowed funds must be less than the multiple of the collateral and the collateral cofactor. This means that the user has borrowed funds that are well within their repayment capacity and within the compensation potential of the collateralized asset. As long as this condition is made, the DeFi platform for borrowing and lending will not have any problem in loaning the amount.
You can easily infer from this equation that the ratio of the collateral to the borrowed amount depends on this collateral cofactor. In the long run, it measures how effective the collateral would be to recover the funds that are provided as a loan if the user fails to repay them. This also stops people from depositing useless tokens as collateral, so they can borrow tokens that are high in terms of market value.
As you may have inferred from what has been written until now, it is evident that DeFi has the capacity and the credentials it takes to displace the existing ecosystem of traditional finance. It might be a bit too premature to think of a completely decentralized financial ecosystem but it cannot be denied that DeFi is slowly catching up.
There are many other aspects and activities of the centralized financial system that DeFi needs to cover. Given the way in which lending and borrowing has been planned and effectively executed by DeFi, at least one of the many aspects of finance has been addressed by decentralized finance platforms and applications.
It is easy for an aspiring crypto entrepreneur to understand the potential that DeFi has come up and if they have to start with something that people are already familiar with, they should probably start with a DeFi Lending and Borrowing platform.
If you are one of those, all that is left for you to do is to get in touch with the company that specializes in the development of DeFi applications. They will take care to understand your exact requirement and get the product developed in line with your business needs. It is just a matter of time before you launch your own DeFi app that specializes in DeFi lending and borrowing.