Offering a clear and practical application for why decentralization, blockchain, and cryptocurrencies matter, DeFi services have been consistently developing and attracting serious interest since their relatively quiet expansion went big in early 2020.
While most people are still getting their head around cryptocurrencies as an entity, decentralized exchanges, payment services and the purchase of derivatives are thriving, showing the traditional banking industry that blockchain can offer a more efficient and democratized way of running financial services.
While DeFi is a huge topic, in this blog post we are going to focus specifically on DeFi lending. DeFi lending definitely makes sense for those that aren’t day trading. If you are holding cryptocurrency, why not use it to earn some interest? For those that are borrowing in the kind of market we’ve seen in 2020 and so far in 2021, interacting with DeFi lending platforms is equally as attractive. At the moment, many are able to use crypto collateral to buy more cryptocurrency, with the price increase of both the collateral and the crypto purchased with loaned funds far outstripping any interest that is accrued.
Of course, there is more to DeFi lending than this, which is what we hope to illuminate in this post. Whether you’re a casual observer who is using centralized cryptocurrency platforms, or someone who is thinking of using DeFi services to take out a Bitcoin loan, we’ll aim to give a general rundown of DeFi lending and answer some of the most commonly asked questions about this sector.
What is DeFi lending?
DeFi lending mirrors the practices you see in the traditional finance world, i.e. providing funds to borrowers with an agreed interest rate and payment timeline. Of course, one of the major differences is that cryptocurrencies make up the majority of assets that are lent and borrowed.
The other crucial differences between traditional lending and DeFi provide us with a model for how finance in general can be better and more efficient.
- Smart contracts as middlemen – With smart contracts, loans are settled faster, and no matter who you are, you’re guaranteed to get the same treatment as everyone else.
- Non-custodial – Decentralized wallets are non-custodial, meaning you alone have control of your funds and are responsible for your own private keys, not a bank employee who works 9-5.
- Lower barrier to entry – Anyone can participate in the money market, regardless of credit score or amount of funds. In the Western world where the gap between rich and poor is increasing, this at least gives those with less disposable income a small slice of the pie.
- Higher interest rates – Pitiful interest rates currently offered by traditional lenders have meant that people are more willing to experiment with DeFi lending, which can offer over 10% APY on certain lend tokens.
- Cross-chain – There is greater flexibility to operate with a variety of products, even those operating on other blockchains.
- Greater incentives for lenders – Aside from higher interest rates, inducements such as governance tokens (more on this later) provide more value for lenders providing funds to some protocols.
From this summary, it is easy to see why the DeFi sector has surged in popularity over the past year. The top DeFi platforms are currently handling billions of dollars worth of cryptocurrencies. However, for mainstream uptake to occur, some risks need to be addressed in a more robust way, as we’ll see in the section on safety later in this post.
How do I borrow from DeFi?
As mentioned above, borrowing from DeFi operates like taking out a loan at your brick-and-mortar bank. You will have collateral, interest rates, and other set conditions to navigate. From a technical point of view, borrowing often involves the following:
1. Setting up a decentralized cryptocurrency wallet, such as those offered by Metamask or Coinbase.
2. Sending the cryptocurrency you wish to use as collateral to the wallet.
3. Connecting the wallet with the crypto funds to the DeFi lending platform that you wish to use.
What to consider when choosing a DeFi lending platform
In short, each DeFi platform runs with changing conditions and interest rates, so many different factors need to be taken into consideration when interacting with a lending platform. Here a just a few of them:
- Collateralization levels – Borrowers typically must over-collateralize when drawing funds from a DeFi application. The amount in question depends on the currency being used as collateral, the currency being borrowed, and the DeFi protocol being used. The general consensus is that it is better to provide more collateral than less, especially with more volatile coins. A large price drop in a collateralized coin can cause funds to be liquidated, resulting in a loss for the borrower.
- Coin to be collateralized – For the most part, Ethereum is the currency that is collateralized in order to take out a DeFi loan. However, with platform upgrades this is changing. Using the MakerDAO protocol as an example, in late 2019, its technology was updated to create a multi-collateral system where among others, BAT, USDC and COMP could be locked up in exchange for borrowed funds.
- Interest across platforms – Like if you were getting a loan from a bank, shopping around will give you an idea of the best DeFi protocols for the coins you want to borrow. This is made infinitely easier with comparison websites such as DeFi Rate and Loan Scan, which allow easy comparison of commonly borrowed and lent coins and their current interest rates across the major platforms.
- Loan types – Compound offers variable rates based on supply or demand, while Aave offers both variable and stable interest loans. Variable-rate loans are riskier, but are often chosen as they generally offer lower interest rates. However, the risk factor inherent to variable-rate loans is multiplied with cryptocurrencies, where coin prices and supply and demand can fluctuate rapidly. Depending on your appetite for risk, you should consider your loan type.
While the collateralized loan method is still the most widely used, Aave, the second-largest lending platform at the time of writing, is offering flash loans, which need no collateral but require the funds to be borrowed and repaid within the same Ethereum transaction. If this condition is not met, the loan is automatically canceled. Who knows what other permutations smart contracts will allow in the near future, but this is just the beginning.
How are DeFi loans enforced?
With DeFi, there is no debt collector that is going to come and bash in your door at 3 am. Loans are enforced through immutable smart contracts and the aforementioned collateralization of assets often needed to borrow in the first place.
How does DeFi interest work?
It’s easy to lend crypto, users simply lock up the cryptocurrency of their choice in a pool of funds that borrowers can draw from. They are rewarded with passive income due to the fees paid when a borrower has returned the amount drawn from the pool, plus any interest/fees that have been accrued.
Platforms such as Compound, in an effort to encourage users to lend funds to their platform, offer governance tokens, which cost hardly anything to create but give everyone involved in the ecosystem voting rights. Not only this, the token is likely to increase in value if held, giving lenders an extra incentive to help the protocol run smoothly and successfully.
Is DeFi lending safe?
There are two types of safety to consider when talking about crypto loans, one concerns the amount of risk that is involved when deploying a particular financial instrument, and the other is the technical safety of a DeFi platform and its smart contracts.
While democratizing lending, borrowing and access to a whole range of financial products is generally a good thing, a lack of understanding of the risks involved, or the inability to properly mitigate some risks, could result in a serious loss of funds and/or penalties should the market change. As discussed above, taking out a normal loan presents challenges, but negotiating loan variables is especially difficult in a market where APYs can skyrocket, as seen with certain cryptocurrencies quickly rising to 40% during the yield farming craze of 2020.
What’s more, without a centralized repository that can help recover personal information, users are wholly responsible for their funds. Keeping private keys extra secure and inserting the correct wallet numbers and address details is more important than ever, as there is often no recovery option available should funds be stolen or incorrectly sent to a different party. Despite this, many people acknowledge these risks and consider them worth navigating in the quest for a greater share of the growing cryptocurrency market.
Next, there is the technical safety aspect. DeFi is a nascent industry with kinks that are still being ironed out. These “kinks” are often vulnerabilities in smart contracts, which, in the wrong hands, are able to be exploited to the tune of millions of dollars. A recent article published on the website beINcrypto claims that roughly 0.3% of DeFi’s TVL, or $284 million, has been taken through hacks related to platform vulnerabilities since 2019. In another of our blog posts, we also show the biggest hacks of 2020, many of which were perpetrated through “flash loans”. What’s more, unlike traditional banks, these protocols are not backed by any government authorities who can provide support if necessary.
Luckily, in most cases, the DeFi hacked protocol, with its reputation on the line, pays out the lost funds so that its users are not left out of pocket; however, this is not a guarantee.
Which crypto pays the highest interest?
The interest rates for different coins are constantly changing across different cryptocurrency lending platforms, according to variables such as liquidity amounts, or simply whether the platform wants to promote the use of a certain coin. Consequently, there is no singular answer to this question. Usually, stablecoins, which are one of the core parts of a DeFi application, will accrue greater interest than Bitcoin lending, or lending of any of the other major altcoins.
At this point yearn.finance must be given a special mention, as it provides lending aggregation, shifting funds between dYdX, AAVE, and Compound automatically as interest rates change to make sure that a lend coin is consistently being used to provide the best rate of interest.
Although it might seem like a bit of a minefield, with a bit of research and the right products, it is possible to gain a high level of interest with many different cryptocurrencies!
Despite the risks related to blockchain lending, people have not historically taken the same precautions as they would have when interacting with or holding other assets. As the DeFi ecosystem becomes more entrenched in the world of finance, things finally look to be changing with the expansion of DeFi insurance.
DeFi insurance can cover everything from your wallet to the smart contract used to complete your financial transaction. Not only does it bring peace of mind in guarding against things such as lost private keys and hacks, but it is helping to make the DeFi and crypto sphere more legitimate and trustworthy. This is crucial when trying to encourage greater mainstream investment.
What is the best DeFi lending platform?
As we’ve seen from this blog post, crypto lending platforms all operate differently. Comparison websites go some of the way to helping you secure better interest rates, but then there are other factors to consider, such as security, coins on offer, and whether there are any other benefits to using a certain platform, such as one that distributes governance coins.
The largest DeFi products by Total Value Locked (TVL) Maker, Compound, and Aave, offer stability, ease-of-use and thorough documentation, which is great both for people who are taking their first steps, or who want to work with more niche financial instruments. Smaller lending exchanges offer similar operations but will have interesting points of difference, such as Reflexer Finance, which uses a stablecoin that isn’t pegged to the US dollar, protecting itself if fiat currencies were to plunge in a 2008 style financial crash. The best option is indeed to look around and find a platform that offers value for money, usability, security and compatibility.
DeFi lending: a new opportunity
As seen from our short exploration of DeFi crypto lending, despite the teething problems, there is a lot of promise in this industry. With new and better products being developed all the time, DeFi services will transform the industry with investment that is growing every single day.