Blockchain technology has taken the world by storm in the past few years. Its rising popularity resulted from unique decentralised products, which created an air of freedom and autonomy, especially amongst investors.
Decentralised Finance (DeFi) has been one of the fastest-growing contributions to the $3 trillion crypto industry. With its unique products that address a lot of the challenges inherent in traditional financing, DeFi has managed to transform financial instruments globally.
The Dawn of Decentralised Finance
DeFi uses the concept of peer-to-peer interaction to eliminate the need for an intermediary. By making it open-source and transparent, its trustworthiness has gone up manifold with investors from across the globe accessing the network. Unlike traditional financing, transparency helps in reducing the fees that the intermediary ends up taking.
Additionally, DeFi is also permissionless, making it easier for anyone to access the network and utilise its services. By having a permissionless lending protocol, DeFi tackles the most significant challenge users face with traditional financing: that being accessibility. For instance, to obtain a loan, borrowers often have to prove their creditworthiness through their credit scores, and in the process, they end up paying high-interest rates to borrow loans.
A Deep Dive into DeFi Lending
DeFi lending platforms or protocols offer a common ground where lenders and buyers can come together and create the entire lending ecosystem. The lenders are people with a lot of crypto in their wallets and wish to earn passive income from it. The borrowers don’t need to submit tons of documents and pass credit checks to get approvals. However, they will have to deposit collateral in exchange for the borrowed amount.
While it may seem contradictory to offer collateral to take a loan when the borrower could just sell it, there are numerous reasons why it would be beneficial to borrow cryptos instead of selling current investments. For instance, someone who requires emergency funds could find it helpful to borrow crypto instead of selling their investments, especially if they think it will generate good returns in the future. Another reason why someone wouldn’t want to sell their investments is if they want to avoid paying capital gains taxes which become payable if the asset (crypto) is sold. Some investors might also borrow funds to maintain a better trading position in leverage trading.
The lenders and the borrowers enter into an agreement using smart contracts, entirely eliminating the need for an intermediary. Let’s explore how some of the most popular Defi lending protocols, including permissionless lending protocols function.
Popular DeFi Lending Protocols / Platforms: An overview
Some DeFi Lending protocols use tokens that match the value of fiat currencies like INR or USD. DAI follows US Dollar and is the primary token of Maker. The Maker protocol is available for anyone to use and is one of the leading DeFi lending platforms. Users borrow money through DAI tokens and lock their collateral in a vault within the platform. The interest rate protocol for Maker is the governance fees that lenders can collect as part of the operational earnings. MKR, Maker’s native token, is offered to mint and sell, in order to raise more collateral, especially when the value of the collateral decreases. MakerDAO requires 150% collateral against the loan value the borrower needs. In case the value of the collateral drops below the limit, there is a liquidation penalty that is charged.
This interest rate protocol uses a preset algorithm to adjust the interest rates based on the demand and supply of cryptos. Users deposit their cryptos in a pool and receive the same number of Tokens in return, that being Aave’s native token. The volume of Tokens decides the interest amount. Borrowers can borrow funds from this pool. Their collateral must match the value of the loan they wish to take. If a borrower owns Aave’s other native token AAVE as collateral, they get a discount on fees and can borrow a slightly larger amount. If they borrow AAVE, no fee is charged. The non-custodial liquidity platform also provides features such as flash loans that practically require no collateral.
Being a permissionless lending protocol, Compound is open for anyone who wishes to borrow or lend as long as they have a crypto wallet. Users can choose from a wide range of financial instruments to earn from their crypto assets. The interest earned from this platform is in the same cryptos in which it is deposited. In case the value of the collateral drops, the smart contract automatically closes the position by liquidating the collateral so that the lender does not make any loss. This is why the collateral must always be worth more than the amount borrowed.
DeFi makes lending and borrowing extremely seamless for investors from around the world. With its unique financial instruments, DeFi’s growth has transformed the financial ecosystem globally. By offering various opportunities to investors to mobilise their funds, permissionless lending protocols have paved a transparent path for the future, creating more financial freedom for the masses.