DeFi lending and borrowing, explained

What is lending and borrowing in DeFi?

Lending and borrowing, within the realm of traditional as well as crypto finance, entails the act of one party providing monetary assets — be it fiat or digital currencies — to someone else in exchange for a steady income stream.

The concept of “lending and borrowing” has been around for ages and is one of the core aspects of any financial system, especially the “fractional banking” setup that is predominantly used across the globe today. The idea is extremely straightforward — i.e., lenders provide funds to borrowers in return for a regular interest rate, and that’s quite literally it. Also, traditionally, such deals are usually facilitated by a financial institution such as a bank or an independent entity such as a peer-to-peer lender.

In the context of cryptocurrencies, lending and borrowing can be facilitated via two primary routes — via a centralized finance institution, such as BlockFi, Celsius, etc., or through the use of decentralized finance protocols such as Aave, Maker and so on.

CeFi platforms, though decentralized to a certain extent, work in pretty much the same way as most banks, whereby they take custody of one’s deposited assets, eventually loaning them out to third parties — such as market makers, hedge funds or other users of their platform — while providing the original depositor with steady returns. And though on paper this model looks and works quite well, it could be prone to a number of issues, such as thefts, hacks, insider jobs, etc.

DeFi protocols, on the other hand, allow users to become lenders or borrowers in a completely decentralized fashion, such that an individual has complete control over their funds at all times. This is made possible via the use of smart contracts that operate on open blockchain solutions such as Ethereum. In contrast to CeFi, DeFi platforms can be used by anyone, anywhere without them having to hand over their personal data to a central authority.

How does lending and borrowing work on DeFi platforms?

An individual sends the tokens they wish to lend into a “money market” using a smart contract, which then issues interest in the platform’s native token.

When making use of DeFi protocols such as Aave and Maker, users looking to become “lenders” need to supply their tokens into what is referred to as a “money market.” This is done so by an individual sending their assets to a smart contract — which serves as an automated digital intermediary — following which the coins become available to other users for borrowing.

The aforementioned smart contract issues interest tokens that are doled out automatically to the user and can be redeemed at a later stage in place for one’s underlying assets. The tokens that are minted are native to the platform, for example, in Aave the interest tokens are called aTokens, whereas on Maker they are referred to as Dai.

Almost all of the loans that are issued via the native tokens are over-collateralized, which basically means that users who want to borrow funds are required to provide a guarantee — in the form of crypto — that is worth more than the actual loan itself. 

While on paper this may seem somewhat absurd since the person could potentially just sell their assets in the first place to get the money, there are many reasons why DeFi borrowing makes sense. 

Firstly, users may need funds to cover any unforeseen expenses they may have incurred while not wanting to sell their holdings, as the assets may be primed to increase in value in the future. Similarly, by borrowing via DeFi protocols, individuals can potentially avoid or delay paying capital gains taxes on their digital tokens. Lastly, individuals can use funds borrowed via such platforms to increase their leverage on certain trading positions.

Is there a cap on how much money one can borrow?

Yes, and there are primarily two factors that govern this. Does the platform have enough liquidity? What is the “collateral cofactor” of a person’s supplied assets?

There is indeed a limit, and there are two primary factors that govern how much money an individual can borrow. First, it depends on the total fund pool that is actually available to be borrowed from a particular market. And while this may not be a major issue, it could become a factor if someone actually tries to borrow a really large volume of a certain token.

Secondly, it’s largely dependent on the “collateral factor” of one’s supplied tokens. This term refers to the total amount of funds that can be borrowed based on the quality of the collateral provided. For example, Dai and Ether (ETH) possess a collateral factor of 75% on the DeFi lending platform Compound, which means that users can take a loan of up to 75% of the value of their supplied Dai or ETH.

On a more technical note, those who borrow funds must have the total value of their borrowed amount stay under the following limit — the value of one’s collateral multiplied by its collateral factor. As long as this condition stays valid, an individual can borrow as much money as they want.

What are the mechanics of how interest returns are doled out in DeFi?

One picks a coin that they want to lend as well as the smart contract using a DeFi app, then the interest amount is supplied directly to the associated wallet.

To cut a very long story short, the interest that lenders receive and what borrowers have to pay is calculated by using the ratio that exists between the supplied and borrowed tokens in a particular market. Also, it should be noted that the borrow annual percentage yield is higher than the supply APY in relation to a particular market. 

On another technical note, interest APYs are determined per Ethereum block, which means that DeFi lending entails users being provided with variable interest rates that can change dramatically depending on the lending and borrowing demand for particular tokens. Also, some protocols, such as Aave, offer their users stable “borrow APYs” as well as flash loans, for which no upfront collateral is required.

Are there any risks involved?

DeFi protocols feature certain risks, such as third-party smart contract tampering and the risk of borrow APYs rising dramatically within a short time period.

When compared with centralized finance, there are no practical dangers associated with DeFi lending. However, like anything else, DeFi, too, has risks associated with it. For example, there are certain smart contract risks that are present as well as the threat of APYs changing dramatically within a short time window. 

For example, during the DeFi craze of 2020 where “yield farming” became a rage globally, borrow APYs on certain cryptocurrencies rose to 40% and over. This could have potentially caused unaware users who may not track their interest rates daily to repay more than what they might have initially expected.

Overall, while the entire process of lending and borrowing using DeFi platforms is not really complicated, there are certain small differences in terms of how each specific protocol operates, for example, the various wallets they support, applicable fees, etc. 

Furthermore, users still have to be cautious and ensure that they have inserted the correct wallet numbers and address details so as not to end up losing their funds since there is no way to recover them in such a scenario.