How Defi Lending Works: Your Guide to Decentralized Lending and Borrowing

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The concept of lending and borrowing makes up the foundation of financial systems. The idea is quite simple – lenders provide funds to borrowers in exchange for repayment plus interest. Such transactions are usually carried out with the assistance of a financial institution, bank, or an independent organization, such as a peer-to-peer lender.

On the topic of lending and borrowing using cryptocurrencies, there are two accepted methods used to organize a loan – using a centralized financial institution (CeFi) or decentralized financial protocols (DeFi). 

This article will look more closely at how DeFi lending works, along with the advantages and nuances present in this type of lending. 

The Difference Between CeFi and DeFi

For the most part, CeFi (centralized finance) platforms operate like traditional banks. They take escrowed assets into custody, ultimately lending them to third parties such as market makers, hedge funds, or other users – providing the initial investor with a stable profit. While this model looks and works reasonably well on paper, it can be vulnerable to some problems such as theft, break-ins, insider trading, etc.

DeFi protocols, on the other hand, allow users to become lenders or borrowers in a completely decentralized manner so that the individual retains complete control over their funds. This is made possible by using smart contracts that run on open blockchain solutions such as Ethereum. Unlike CeFi, DeFi platforms can be used by anyone, anywhere, without the need to transfer their personal data to a central authority.

How does DeFi Lending Work? Types and Benefits

DeFi lending works by engaging system participants to contribute their funds by depositing them at interest. The pool of assets for all users is distributed among those wishing to obtain a loan secured by collateral.

There are two types of rates on these platforms: 

  • On deposits – the interest that the investor receives
  • On loans – the interest that the lender must return.

The amount of interest mainly depends on two factors. The first is the amount of the loan for the cryptocurrency in which the loan is issued and the demand for it. The second is the asset that is used as collateral.

The interest rates are not fixed. For example, the fewer funds that are available for withdrawal, the higher the deposit rate. The rates for different services may change several times. The range of interest rates is from 2% to 10%.

One of the leading Ethereum-based lending services is AAVE. Powered by Binance Smart Chain – Venus.

The main benefits of DeFi lending are:

  • Anonymity. You do not need to reveal your identity or share private data to get a loan.
  • Simplicity. You can get a loan for the amount you need in a few clicks. No paper bureaucracy or “Your loan is not approved”.
  • Transparency. DeFi lending platforms are built on public blockchains. This means that any user can check the terms and specifications of smart contracts and understand how the system works.
  • Easier access to the market. Since DeFi is an open and transparent ecosystem, anyone with internet access and their own crypto wallet can join it. It doesn’t matter what your location or credit history is. 
  • Eliminating intermediaries. Smart contracts allow lenders and borrowers to sign a contract directly, allowing lenders to earn more and borrowers to borrow at lower interest rates.
  • Low percentage. For most cryptocurrencies, the rate ranges from 5-8% APY. An excellent alternative to microloans around the corner and banks, which charge about 20-30% on small amounts.
  • Immutability. Thanks to decentralized architecture, lending processes are tamper-proof and secure.
  • Compliance with regulations. For traditional financial institutions, such as banks, no one can guarantee compliance with international, state, and local regulations due to the human factor involved. With DeFi lending, you can agree on laws and regulations when creating a smart contract. This ensures that all regulations are enforced.

What is the Limit on a Loan?

Two main factors determine how much money a person can borrow.

First, it depends on the total pool of funds available for borrowing in a particular market.

Second, it largely depends on the “side factor” of the tokens provided. This term refers to the total amount of funds that can be borrowed depending on the quality of the collateral provided. For example, Dai and ETH have a collateral ratio of 75% on the DeFi Compound lending platform, which means users can borrow up to 75% of the lent Dai or ETH value.

What are the Risks of DeFi Lending?

Like everything else, DeFi isn’t without its own risks. For example, there are certain risks involved with smart contracts and the threat of a sudden change in APY (Annual Percentage Yield) within a short time window.

Overall, while the entire lending and borrowing process using DeFi platforms is not complicated, there are minor differences in how each specific protocol works, such as the different wallets they support, applicable fees, etc.

In addition, users must still take care to ensure that they have entered the correct wallet numbers and address details so that they do not lose their funds as they cannot be recovered in such a scenario.

In Conclusion

The market for decentralized finance, including cryptocurrency lending, will continue its steady pace of evolution. Startups need to consider the needs of clients, including the fact that not all of them can provide collateral that exceeds the amount of a loan that is requested.

If you are looking to ride out a trend by building your own DeFi lending platform, start with a professional consultation. The Unicsoft team is here to guide you through all the necessary steps to help you develop your ideal lending platform while taking resources and needs into account.