Getting started with Decentralized lending and borrowing with DeFi

In this second article in the DeFi series, we’ll discuss about decentralized lending and borrowing with DeFi. If you’d like to brush up your understanding of DeFi, check out my previous article that explains what DeFi is, its benefits and some of its products.

Now that we have a basic understanding of DeFi, it is time to look into one of its most important use cases- borrowing and lending. Most of us would be familiar with the traditional methods of borrowing and lending. If a person need to borrow some money to buy a house, their first instinct would be to go to a bank and take out a house loan. However, banks are essentially businesses, they generally charge high rates of interest, which can lead to a great loss of money on the borrower’s side. Additionally, banks may resell your loan to another bank or financing company and this may mean that fees and procedures may change—often with little notice.

Some people may join a credit union. Credit unions offer many of the same services as banks. But they are typically nonprofit enterprises, which helps enable them to lend money at more favorable rates or on more generous terms than commercial financial institutions. However, despite the lower rates of interest, they are unable to provide the variety of loan products that banks do. 

Trusting a central authority with your assets and money can be nerve-wracking. This is because they are susceptible to human error, fraud and corruption. Fairly rare, but its a big possibility. There are several occurrences of higher-level bank officials who make human errors and commission loans unethically. For example, take the Yes Bank fiasco. 

In 2015, UBS, a global financial services company, raised the first red flag about the bank’s asset quality. The UBS report stated that Yes Bank had loaned more than its net worth to companies that were unlikely to pay back. However, Yes Bank continued to extend loans to several big firms and became the fifth-largest private sector lender This caused a serious deterioration in the financial position of the Bank, and the RBI had to supersede the Yes Bank’s board of directors. They placed the bank under moratorium and capped withdrawals at Rs. 50,000. This decision caused a great deal of inconvenience to all the stakeholders associated with the bank. Such situations have led to serious trust concerns with the traditional method of borrowing and lending money. But what if it was possible to rule out the centralized nature of financial systems?

How would such a system even work? 

Peer-to-peer lending solves this problem to a certain extent. Essentially, it is a method of financing that allows individuals to borrow and lend money without the use of an official financial institution as an intermediary. Through peer-to-peer lending, borrowers receive financing from individual investors who are willing to lend their own money for an agreed interest rate. Both parties can connect through a peer-to-peer online platform. Borrowers display their profiles on these sites, where investors can assess them to determine whether they would want to risk extending a loan to that person. But this solution comes with its own set of problems. Firstly, it takes up much more time, energy and effort when compared to traditional banks. It also involves a lot of risk, since there is no fail-proof method of tracking and verifying payments. Additionally, these sites may charge loan origination fees, late fees, and bounced-payment fees. But what if we improve on this peer-to-peer lending concept by using blockchain technology?

Decentralized lending with DeFi

The Fintech revolution has provided an opportunity for people to have access to a multitude of financial services, regardless of their financial status or location. DeFi expands on this opportunity by decentralizing the lending and borrowing process. This leads to better security, accountability and transparency in the financial system. According to research conducted by Messari, DeFi lending is the top-performing category in terms of ROI, followed by decentralized exchanges and DeFi payments.

Total U.S. dollar value locked in DeFi lending protocols increased 75% in the past year. HTTPS://DEFIPULSE.COM/

Let’s take a look at how it works-

• DeFi’s open lending protocols is similar to a bank’s protocol- Users can deposit their money and when someone borrows their digital assets, they earn an interest. However, instead of an intermediary, there are smart contracts to dictate the loan terms.
• Once the smart contract has been deployed on the blockchain, it is self-executing and can’t be stopped unless both parties agree. 
• Due to the transparency and immutability of the blockchain, the lender earns high returns and is able to assess the risk more clearly.
• The standardization and interoperability of the system can also minimize costs with automation.

Crypto loans and decentralized borrowing with DeFi

Now that we have discussed decentralized lending, let’s take a closer look at the borrowing process. Similar to the lending process, decentralized borrowing is extremely secure.

The typical process involved is as follows-

• A borrower obtains fiat loans from lenders in lieu of their crypto assets like, which act as collateral in absence of repayment of the loan.
• The exchange of crypto loans happens between the lender and the borrower once both parties accept a specific interest rate on the loan. Similar to a traditional loan, the crypto loan amount is deposited in the borrower’s bank account and then the borrower pays EMI’s to the lender. Once the amount is paid back in full, the lender releases the collateral that acted as security.
• Conversely, borrowers can also use their fiat currencies as collateral to obtain crypto assets.
• Crypto loans usually take place on DeFi lending platforms, where lenders and borrowers can interact directly without a middleman.

Litmus test for your DeFi dApp

The follwing are a few basic characteristics of a DeFi app. However, these are not strict defining factors for a DeFi dApp as many of the existing DeFi apps in the market do not all of there characteristics. 

• The dApp offers a service/product available in legacy banking and financial services such as trading, lending, funds etc in a decentralized p2p channel. 
• The user of the dApp needs to connects their crypto wallet to the decentralized blockchain network. For example, if its an ethereum based dApp, user need to connect their walet to blockchain using metamask  or other such services.
• The assests are 100% under self custody. There is no custodian to manage the assets of the user. 
• All transactions, processes, workflows of the app are handled via smart contracts and a thirdparty involvement is not possible. 
• No access restrictions. Anyone interested should be able to use the app with out any restrictions such as geographical, jurisdictional, minimum usage limits etc. 

DeFi lending and borrowing platforms 

DeFi lending and borrowing platforms allow users to deposit and lock their funds into smart contracts, from where other users can borrow and pay interest on them. Each loan is collateralized by crypto. Let’s take a look at some of the popular DeFi platforms being used today-

Compound

Compound is an open-source and decentralized protocol allowing users to earn interest on Ethereum digital assets by lending them for acquiring real-world assets like real estate, vehicles, or commodities.

Here’s how Compound works:

• Investor signs a transaction and approves the funds they’d like to lock using the protocol.
• The asset is instantly added to the global supply pool.
• Users borrow an asset directly from the protocol by simply specifying the asset they wish to borrow.
• Generated profit gets distributed among the investors with interest being tracked in real time.
• Each asset gets tokenized through cTokens and has its own market with interest rate based on the supply and demand. cTokens also let the user move and trade locked assets through various Apps.
• Within Compound, there is a withdraw function which allows users to convert the cTokens to the original assets (e.g., from cBAT to BAT).

Aave

Aave is an open-source protocol that uses a pool strategy to adjust the interest rates algorithmically. Some of the unique features that can be seen on this platform are-

• Aave’s Flash Loans – These Loans can be obtained without depositing any collateral and virtually at no cost. Flash Loans rely on loan repayment timing. As long as the loan is borrowed and paid back within the same transaction it was issued, it gets approved. If the loan is not paid back in the same transaction, the loan is canceled.
• Aave’s Algorithm – The protocol’s core mechanism keeps track of the liquidity reserve and collateral price fluctuations. If the value of collateral drops below a threshold, users can get a discounted price as a bonus for liquidating their loans. By working this way, Aave makes sure that the contract pool maintains a certain minimum amount of liquidity.
• Aave’s Rate Switching – This feature offers the flexibility to combine stable and variable rates to achieve the most profitable outcome.

The ecosystem has its aTokens for paying interest and LEND tokens granting voting rights for decisions related to the protocol parameters and smart contract upgrades.

Nuo Network

Nuo Network is a decentralized debt marketplace that connects lenders and borrowers across the world using smart contracts. There is no native token and the interest rates are adjusted algorithmically. 

• Lending – Lenders earn interest by adding collateral to debt reserves which is used to fund loans and trades and receive a share of the daily interest paid by borrowers, in proportion to their share in the debt reserve.
• Borrowing – Borrowers can take loans of up to 70% of their collateral’s value. What’s more, Nuo allows users to over-collateralize their loans which then can be withdrawn from the platform.
• Margin Calls – Nuo monitors margin positions off-chain (centrally) and calls contracts when a position has gone under margin maintenance. In case the price feed confirms the position to be under margin maintenance, Nuo executes a liquidation.

MakerDAO

MakerDAO is a decentralized protocol that is made up of a smart contract service that manages borrowing and lending, as well as two currencies: DAI and MKR to regulate the value of loans. On MakerDAO, there are no lenders, and the only asset available to borrow is DAI. 

• Borrowers can borrow a newly created supply of DAI by locking up ETH as collateral, and must maintain a 150% collateralization ratio. The interest rate on DAI is global, and is set through governance by MKR token holders. 
• Vaults that fall below the 150% collateralization ratio are subject to a 13% penalty and liquidation (by anyone) to bring the Vault out of default. Liquidated collateral is sold on an open market at a 3% discount.
• Maker has a feature called the Dai Savings Rate (DSR). DAI holders can lock their DAI into Maker’s DSR contract and earn a variable interest rate in DAI, which is generated from stability fees.

These decentralized platforms offer several benefits like added security, transparency & accountability with no requirement of credit checks. This makes them a very attractive option. However, most of them involve the use of cryptocurrency, which can be a challenge for people who are not familiar with it. That being said, decentralized lending and borrowing with DeFi is evidently much more effective than the traditional practices that many of us use today.