Introduction to Lending and Borrowing in DeFi
Lending and borrowing is a core aspect of the financial system. Most people interact with loans at some point in their lives. Loans in the form of student loans, mortgages on houses and credit card loans are common. In essence, people with excess capital act as lenders and provide the funds to borrowers at a mutually agreed cost called an interest rate.
In traditional finance, lending and borrowing takes place through financial institutions, such as banks or peer-to-peer lending institutions, that control access to funds, and therefore the cost of borrowing. These lending and borrowing institutions are also known as money markets. We’ve seen something similar in the CeFi crypto space where institutions like BlockFi borrow money from retail investors and lend them to institutional investors at a higher interest rate.
DeFi lending and borrowing have provided users access to funds in a more capital-efficient and transparent way, as compared to TradFi or CeFi.
This blog is an introduction to how lending and borrowing works in DeFi.
Lending and borrowing in DeFi
DeFi allows lenders and borrowers to participate on permissionless protocols while maintaining full custody of their tokens. These protocols are created using smart contracts and are run on Layer 1 blockchains like Ethereum or Layer 2 solutions like StarkNet.
DeFi lending and borrowing allows anyone to become a lender to earn passive income on their crypto, or a borrower by using their deposits as collateral on the same platform as long as certain criteria are met. We will discuss more about the criteria below.
But before we do that, let us see how you could become a lender or borrower on some of the most popular money markets in DeFi.
Most money markets like Aave or Compound provide liquidity pools for the most liquid tokens in the crypto space. People holding excess ETH, stablecoins like USDC or DAI, wrapped BTC etc. can deposit their tokens into different pools created by these platforms.
The supplied tokens are sent to a smart contract that allows borrowers to borrow from them. In exchange for the deposits, the lenders receive a token that represents their deposits, along with the interest they will accrue on their deposits.
Aave deposited tokens are called aTokens whereas Compound deposits are called cTokens. A lender can redeem their original tokens alongside the interest earned by burning these tokens on the platform.
From a borrower’s point of view, all loans on DeFi are overcollateralized. This means that a user who wants to borrow funds has to supply tokens in the form of collateral that is worth more than the actual loan that they want to take.
Now if you’re wondering, why would someone deposit tokens worth more than the loan amount, there are a few possible answers:
- Users may not want to sell their tokens since they believe their prices will go up.
- Users may want to avoid paying capital gains tax that they would have to pay if they sold their tokens.
- Users may want to borrow tokens to then short them or to leverage their existing collateral position on the platform.
- Users may want to deposit the borrowed tokens on a DeFi options vault or on another asset management protocol.
The two important factors to consider while borrowing a token are:
(1) whether the pool has enough tokens for you to borrow and
(2) the collateral factor of the tokens in the pools.
Not everyone deposits stablecoins as collateral to borrow cryptocurrencies. Borrowers must therefore ensure that their loans are always overcollateralized, meaning that if the collateral factor on a protocol is 75%, then a borrower can only borrow up to 75% of the total deposits in the pool.
If the collateral value falls below the required collateral level, then the user’s position gets liquidated to repay the borrowed amount to the protocol. Since this is all smart contract coded, the only risk involved on such platforms is smart contract risk, as compared to default risk or counterparty risk which could be experienced in TradFi or CeFi.
Interest rate for lenders and borrowers
The interest rates in these money markets are calculated for each block of the underlying blockchain and are therefore floating in nature.
They fluctuate depending on the demand and supply of the tokens available in each pool. If there is a huge demand for a token and less supply for it, then borrowing APY for the token will be high in comparison to a token where there is an excess supply of the token in the money market.
This is just an introduction to DeFi lending and borrowing. Our future blogs will cover some interesting information about money markets, useful applications and also the new innovations that make DeFi lending and borrowing more capital efficient and user-friendly.
Disclaimer
The information provided in this article is provided for informational purposes only and does not constitute, and should not be construed as, investment advice, or a recommendation to buy, sell, or otherwise transact in any investment, including any products or services, or an invitation, offer, or solicitation to engage in any investment activity. You alone are responsible for determining whether any investment, investment strategy, or related transaction is appropriate for you based on your personal investment objectives, financial circumstances, and risk tolerance. In addition, nothing in this article shall, or is intended to, constitute financial, legal, accounting, or tax advice. We recommend that you seek independent advice if you are in any doubt.
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