defi lending and borrowing

This article aims to provide insight into the what, why, and how of decentralized finance (DeFi) borrowing and lending. It references cryptocurrencies, blockchain technology, staking, and farming. If you are unfamiliar with crypto, read our articles on blockchaincrypto, and DeFi before reading this article.

Traditional Finance (TradFi) has used a fractional banking approach of lending capital to receive interest payments using an intermediary, i.e., banks and other financial institutions. However, this centralized system is not open to all and requires participants to go through stringent or structured procedures and verification processes to acquire loans, mortgages, and other forms of capital. 

DeFi is an open, permissionless, and transparent space where users can acquire loans without the need for external parties such as banks and other centralized financial institutions. Compliance with the terms of loans by both parties is ensured through smart contracts, which are employed on the blockchain instead of conventional financial risk functions.

traditional finance (TradFi) vs. decentralized finance (DeFi)

How Is DeFi Different From TradFi?

DeFi can provide financial services to a broader audience, democratizing them by including participants who cannot access TradFi services. DeFi is also less intrusive on privacy since assets are held in self-custody rather than a third-party. TradFi has achieved both interoperability and integration to a considerable degree, however, its centralized nature remains as a huge drawback. Achieving a high level of cross-chain interoperability and composability, while still maintaining decentralization, is thus one of the most imperative goals of DeFi adoption and growth.

Why Participate in DeFi Lending and Borrowing?

Lenders can gain value on their already owned crypto assets by lending them out to earn interest. Lending also helps to offset inflation risk on their investments. Borrowers can receive the funds provided by the lenders so long as they can overcollateralize the said amount in the form of other digital assets. Borrowing more capital in the form of stablecoins or protocol tokens to farm or stake tokens is an effective method to earn additional income. 

Learn more about DeFi risks here!

Where Does DeFi Stand as Compared to TradFi markets?

DeFi protocols have remarkably contributed to the overall crypto markets in the past few years. The total value locked (TVL) of DeFi was less than $US20B at the start of 2021 and currently sits at over $US209B in TVL at the time of writing (March 2022). The TradFi services market is expected to grow to US$28.5T by 2025 and is comparatively much bigger than the current DeFi can offer more significant return percentages. This real-world use case has attracted and onboarded many participants.

Why Are Interest Rates So High in DeFi?

Similar to how a user can deposit funds into a TradFi savings account to accrue interest, crypto holders can do the same while receiving interest rates that are significantly greater than the TradFi space, which leads to an attractive way to generate passive income. TradFi interest rates usually range from 0% to 3% depending on the amount deposited, but DeFi can provide you with higher rates of interest, varying from 5% to 10%, which is possible due to the elimination of intermediaries.

Curve (CRV), Maker DAO (MKR), and Lido (LDO) are currently the three biggest protocols with a combined TVL of over US$53B

Collateralization in DeFi Borrowing

As most DeFi lending applications do not require traditional credit and background checks, potential borrowers are required to overcollateralize their loan to hold them accountable for repaying the debt. Overcollateralization means that the collateral value will exceed the loan value. This requirement helps mitigate risk. 

Possible Risks in DeFi Borrowing

Borrowing from protocols can often be risky as the loan-to-value ratio (LTV) needs to be cautiously monitored to ensure that the collateral requirement which was previously agreed upon is steadily maintained. Due to the volatile nature of crypto assets, the posted collateral is constantly subjected to price fluctuations. Volatility leads to the problem of loan liquidations as borrowers are often not protected against these circumstances by loan insurance.

Centralized Lending in DeFi

Many centralized crypto companies can provide stable returns on crypto assets. Users who interact with these centralized exchanges have to go through verification and know-your-customer (KYC) compliance. Stable returns are guaranteed as the exchanges set them instead of relying on supply and demand, which are affected by market conditions.

Tools You Can Use to Navigate DeFi

Due to the ever-changing and fast-paced nature of the DeFi space, users interact with a range of platforms, protocols, and assets. It can be overwhelming when new users first enter the space but fret not, as there are many great tools available to integrate you into the DeFi ecosystem seamlessly! From helping you check market updates, news, and interest rates to efficiently managing your trades and positions, the DeFi space has got you covered. 

  • Crypto Twitter (CT) is a great place for users to interact with DeFi builders, traders, investors, and more.
  • CoinMarketCap and CoinGecko provide up-to-date prices, charts, and watchlist features.
  • Wallets such as Metamask and Coinbase help you hold your assets (Wallets can be Custodial and Non-Custodial).
  • Brave Browser is a web browser extension that helps you provide you with data privacy.
  • DeFi Pulse is a great resource for keeping track of rankings, TVL (Total Value Locked), analytics, and data on various DeFi protocols.
  • DeFi analytics dashboards such as Harvest help you track your Profit/Loss of assets, liquidity investments, and lending/borrowing transactions.

We at Treehouse Finance make sense of transactions and public blockchains to provide you with the most meaningful and comprehensive insights to power and support your next move. 

Future Outlook

The heights that the DeFi space has ascended to would not have been thought possible just a couple of years ago. Still, despite the waves it has created on the financial industry as a whole, the system and processes in place do not come without some drawdowns, which can be instrumental in either propelling or halting the rapid progress of this space. Overcollateralization of loans is an aspect that needs to be addressed, as demands for loans fall as numbers of lenders increase and borrowers decrease. Underutilization of assets in regard to lending also contributes to the problem of limited interoperability. While trying to attract more interest and drive more attention to this space, it is also essential that users actively operate across chains with minimal complications while performing actions such as token transfers. Collaboration and simplification of the current process will be pivotal to better user experience and accessibility. 

There are also many technical, regulatory, and asset risks that need to be cleared before the gap can be bridged to TradFi. Having taken into account current and future risks and use-cases, DeFi seems to be poised to take off to start competing with TradFi.

Disclaimer

This publication is provided for informational and entertainment purposes only. Nothing contained in this publication constitutes financial advice, trading advice, or any other advice, nor does it constitute an offer to buy or sell securities or any other assets or participate in any particular trading strategy. This publication does not take into account your personal investment objectives, financial situation, or needs. Treehouse does not warrant that the information provided in this publication is up-to-date or accurate.


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