Beginner’s Guide to Lending and Borrowing in DeFi

Last updated on July 11th, 2023 at 11:31 pm

For decades, humans have been starved for options when it comes to availing of financial services. With DeFi, this comes to an end.

While DeFi doesn’t remove the existing system, it offers users of financial services an improved and transparent version of traditional finance. DeFi projects aim to provide similar services to TradFi, but in a user-first manner by removing the intermediaries involved in the process.

Lending and borrowing are functions of the financial system that until now have been limited to banks and financial institutions. DeFi has introduced creative ways to improve financial inclusion and allow users from anywhere around the world to access lending and borrowing services.

Let’s take a closer look at how DeFi is revolutionizing lending and borrowing services.

What Is Lending and Borrowing?

Lending and borrowing are arguably some of the most used financial services. Everyone around the world has at some point been exposed to borrowing, usually by taking out a loan or to lending by depositing money in banks.

In TradFi, the process of lending and borrowing is facilitated by banks or peer-to-peer lenders. They act as intermediaries who take the funds from the lenders and give them to the borrowers. In the process, lenders deposit the funds with financial institutions and earn interest by doing so. Borrowers who need the funds can collect them from the financial institutions by paying interest on the amount they want to borrow.

The area of TradFi that specializes in the short-term lending and borrowing of capital is called the money market. This provides lenders and borrowers access to multiple instruments such as T-Bills, Repurchase agreements, or Certificates of Deposits (CDs).

Lending and Borrowing In Crypto

In the world of cryptocurrency, things work a little differently. Even in the same crypto market, users have access to two different types of service providers in the form of CeFi custodian companies like BlockFi and DeFi protocols like Aave.

However, CeFi platforms are not much different from banks. In a way, you can call these companies crypto banks. This is because these companies take custody of the assets of the lender and then lend out the funds on their behalf to either institutions or users on the platform. Since they operate like TradFi institutions, they are susceptible to similar problems and barriers such as bad loans or losing customers’ deposits by hacks, etc.

Wait, doesn’t that mean that CeFi companies essentially go against one of the most important value propositions of crypto – self custody of assets?

Yes, it does, and this is where DeFi comes in.

Lending and Borrowing In DeFi

DeFi enables lending and borrowing of assets in a completely decentralized and permissionless manner. DeFi protocols put the users in control. By allowing users to become lenders or borrowers, DeFi protocols give complete control to users over their funds at all times. 

This is made possible with the application of smart contractors that run on open blockchains like Ethereum. Since blockchains and DeFi protocols are open to everyone, they can be accessed by anyone, anywhere around the world without having to share your personal data with any central authority.

How Lending and Borrowing Work in DeFi

Maker, Aave, and Compound are the leading lending and borrowing protocols in DeFi. All these platforms create money markets for specific tokens like wrapped BTC, USDC, ETH, DAI, etc.

On these platforms, lenders supply their tokens to the money market of that specific token and receive interest for doing so. The rate of interest depends on the current supply APY of the particular money market.

These tokens are then sent to a smart contract. Borrowers can avail themselves of these tokens through the smart contract. When a borrower takes the funds, the lender is issued tokens that represent the supplied tokens plus the interest by the smart contract. These tokens can be redeemed later for the underlying asset. For instance, these tokens are called aTokens in Aave and cTokens in Compound.

Benefits Of DeFi Lending

Now that we have developed a better understanding of what DeFi lending is and how it works, let’s take a look at some of its major benefits:

• Self custody – DeFi enables users to always be in control of their funds and data.
• Interoperability – DeFi protocols can integrate their products and services with each other. This allows the platforms to complement one another and offer many options to the users.
• Immutability – Built on the blockchain, DeFi increases the security and auditability of the platforms. Also, they ensure tamper-proof data coordination.
• Programmability – DeFi lending protocols make use of smart contracts in their service offering. This enables them to automate redundant operations and execute them with high efficiency.
• Transparent – Since DeFi protocols make use of the Distributed Ledger Technology (DLT), every transaction is made public. 
• Permissionless – DeFi platforms are open and permissionless. Anyone from anywhere around the world can access the services. All they need is a crypto wallet.
• Unique features – DeFi lending protocols like Aave offer products like flash loans where borrowers can take funds without having to put any collateral up front for a short period.

Risks Associated With Lending and Borrowing In DeFi

While DeFi overcomes many shortcomings and reduces risks associated with CeFi, it poses its own risks, which include:

• Impermanent Loss – When lenders provide liquidity to liquidity pools on DeFi platforms, they face the risk of impermanent loss. This loss occurs when the price of an asset in the pool changes and the lenders lose value as opposed to if they had just held the assets in their wallet.
• Flash Loan Attacks – Unique to the DeFi space, flash loans are uncollateralized loans given out to borrowers for a short period. They are essentially a type of unsecured loan that leverages the smart contract functionality in order to reduce the risks associated with TradFi. Flash loan attacks are scenarios where bad actors borrow huge amounts of money and use them to manipulate the market and exploit other DeFi protocols for personal gain.
• No Credit Scores – Because the entire space is decentralized and permissionless, there is no concept of credit scores. This information can be vital for lenders’ safety but at the moment, there is no such feature in DeFi protocols.
• Rug Pulls – As there is no regulation, users have to trust protocols with their funds. Some DeFi developers misuse this trust and create rug pull scenarios which are sort of an exit scam. One of the most popular DeFi rug pulls is when in 2020 one of SushiSwap’s founding developers liquidated all his SUSHI tokens to raise over a billion dollars in collateral. 
• Smart contract – Smart contract risks are ever-present in DeFi. This is because the protocols and smart contracts are built on codes and no code can be perfect.
• Quickly changing APY – The quest to earn higher returns through yield farming motivates liquidity providers to quickly change liquidity pools and opt for the one offering the highest interest rate. For example, once the borrowing APY on the BAT token on Compound protocol increased to over 40%. As a result, users who were not tracking the interest rates daily were at the risk of getting liquidated. 

In Conclusion…

• DeFi lending has tremendous potential so much so that it can even reshape the entire TradFi space by decentralizing its core services. However, while the growth potential is immense, it poses unique risks that can damage retail investors greatly. That being said, with time as the market and DeFi protocols mature and pass the test of time, these risks and concerns are likely to reduce.

What are your views on DeFi lending and borrowing?

What is your favorite platform and which unique DeFi lending feature excites you the most?

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