In the previous articles, we covered Total Value Locked and Automated Market Makers, two foundational concepts that power the growth of decentralized finance (DeFi). One of the most popular real-world uses of DeFi is for borrowing and lending cryptocurrencies. Let's explore how these activities work in the decentralized world.
Why lend and borrow crypto assets?
Lending and borrowing of digital assets unlocks several key benefits:
- Earn passive income: Lenders can earn attractive interest rates on their crypto by providing liquidity to pools.
- Leverage trading: Borrowers can amplify gains by borrowing assets to trade with more capital.
- Short selling: Shorts allow betting against the price of an asset without owning it initially.
- Increase capital efficiency: Projects can raise capital efficiently by using tokens as collateral for loans.
- Fiat off-ramps: Loans allow accessing fiat money while continuing to hold the crypto assets.
These use cases make crypto lending an essential pillar of the DeFi ecosystem.
How does decentralized lending and borrowing work?
Dedicated lending and borrowing platforms like Aave, Compound and MakerDAO facilitate these activities in DeFi:
- Users supply crypto assets to liquidity pools to earn interest – Supplying ETH to Compound for example.
- Interest rates adjust based on supply and demand – More demand pushes rates higher to incentivize more suppliers.
- Borrowers can take out crypto loans by locking collateral – Taking a USDC loan against ETH collateral on Aave.
- Outstanding loans are liquidated if collateral ratio falls too low.
- All transactions are managed by smart contracts with no middlemen.
AMM technology enables assets supplied to be seamlessly matched with borrowers in a decentralized manner.
Key benefits of decentralized lending
DeFi lending offers several advantages over centralized finance:
- Permissionless: Anyone can use DeFi lending platforms without approvals.
- Transparent: All transactions and rates are visible on-chain.
- Censorship resistance: No one can revoke access or manipulate rates.
- Composable: Lending protocols integrate seamlessly with other DeFi services.
- High interest rates: DeFi offers attractive yields largely unavailable in traditional finance.
- Collateral flexibility: Various crypto assets can be used as collateral beyond just BTC or ETH.
By eliminating rent-seeking intermediaries and controls, DeFi expands access to capital and enables free crypto lending markets to emerge.
Risks and pitfalls of crypto lending
While promising, crypto lending also comes with some unique risks:
- Volatile collateral: Sudden price drops can cause insufficient collateral coverage.
- Technical glitches: Smart contract bugs could jeopardize fund recovery.
- Liquidation losses: Partial losses can occur if liquidated asset crashes in value.
- Procyclical liquidations: Market downturns can trigger large scale liquidations.
- Regulatory uncertainty: Evolving regulations around crypto lending.
By understanding these risks, users can make informed decisions and implement prudent risk management strategies.
Outlook for the future
Decentralized lending unlocks exciting new possibilities in the world of cryptocurrencies. Although risks exist, the transparency, freedom and efficiency of DeFi lending offers compelling advantages over legacy systems. As the technology matures and adoption grows, DeFi lending is poised to become an integral component of the crypto ecosystem.