How to Start Lending & Borrowing in DeFi Today
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How to Start Lending & Borrowing in DeFi Today
In today's post we educate you on where to lend/borrow, what the risks are, how to earn yield and define core protocols of DeFi
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And currently, the rates for stablecoins are 6%+ which is about 60x what you are getting in a savings account right now.
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I use all three of these consistently, with Aave being the most commonly used due to their accessible DeFi collateral (eg: $SNX, $xSUSHI, $AAVE, $YFI) etc etc.
Take your time. Its a journey, not a sprint.
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How to Start Lending & Borrowing in DeFi Today
Guest Post, DeFi Slate DAO Contributor Master Roshi
How Lending & Borrowing in DeFi Works
A key innovation in DeFi is that it makes peer-to-peer lending and borrowing easier than ever. It is also maybe the simplest and most fundamental layer of DeFi as well. How lending and borrowing in DeFi works is based around smart contracts. DeFi protocols like the ones we will take a deeper look at in a second, Maker, Aave and Compound all offer pools (smart contracts), also known as money markets, that users can deposit and withdraw their assets from in order to lend and borrow in an incredibly simple manner.
The most common use case of one of these protocols would look something like this; a user has some ETH (or another asset) that they are holding and need to get some short term liquidity to do anything from cover a short term expense to add to their position in said asset or a different one. In any case, what they don’t want to do is sell their assets outright because they believe they are going to go up in value. So what they do is they go to a DeFi protocol and use their assets as collateral to borrow against. They lock their assets in the “money market” smart contracts we mentioned previously, and from there they can usually withdraw a loan worth 50-75% of their collateral. They can only withdraw this amount compared to the value of their collateral because due to the trustless nature of DeFi, loans must be overcollateralized. This is because to ensure that the lender can get their money back, borrowers must be vulnerable to liquidation, meaning their assets are sold and the profits go to the lender. If loans weren’t overcollateralized and the value of the underlying asset were to drop even 0.1%, the borrower would get liquidated.
That is the use case for a borrower, for a lender the brief version of the use case is simply that if you have some asset sitting in your wallet doing nothing, you might as well put it to use and generate some yield.
On a technical level, how the protocol works to create interest rates without a centralized figure deciding on them is to constantly measure the supply and demand data from the money markets. This simply means that any pool with high liquidity will be relatively cheap to borrow from (low interest rates), and any pool with low liquidity will be expensive to borrow from (high interest rates). One aspect that this system creates is that there are no fixed rate loans (on most protocols) as the way it is currently devised there is no party that can guarantee that rate. Instead, interest rates fluctuate every block (15 minutes) based on the supply and demand data coming from the money market. This causes the potential for sudden, unexpected spikes, but it is pretty rare and we will cover it in the potential risks section.
Benefits Compared to Traditional Finance
Smart contracts have enabled a true innovation in finance. They enable users to cut out the banks who previously acted as middle-men for lending and borrowing, as well as other financial services, and took a generous cut for doing so. Eliminating bankers from the process, and replacing them with code, means that users get much more value out of financial services because they get whatever they were getting out of it before, plus the fee that the banks were taking off the top.
This monetary increase is far from the only benefit to DeFi over TradFi. Users also benefit from the ability to lend and borrow in an instantaneous, remote, semi-anonymous and permissionless manner. This means that a farmer in Kenya can get a loan as easily as a lawyer in Manhattan. Incredible!
Core Projects for Lending & Borrowing in DeFi
Maker is currently the biggest DeFi protocol in terms of TVL (total value locked) with $14.05B and is a pioneer in the space, the first lending protocol on Ethereum. Maker allows users to deposit crypto assets as collateral and withdraw their native stable coin DAI, which is pegged to the value of the US dollar.
Aave is currently the second largest DeFi protocol in terms of TVL at $11.36B, barely inching out Compound. Of the three main protocols Aave is probably the one currently pushing the boundaries of DeFi the most. Aave allows users to both take out both uncollateralized “flash” loans as well as fixed rate loans. Uncollateralized flash loans work by allowing users to withdraw and repay loans within the same Ethereum block. They are used for more complicated financial strategies like arbitrage opportunities, self liquidation, and more. The reason they work is because the funds are designed in a way that they are auto returned to the pool at the end of each block. Aave also offers fixed rate loans by allowing users to agree to a higher rate in exchange for the rate to be guaranteed, basically buying insurance against a drastic increase in interest rates. It is important to note that while Aave does offer these services they are mainly on the fringes and the majority of their loans operate on the standard variable rate model that they other protocols employ.
Compound, coming in at $10.93B TVL, made their biggest contribution to the DeFi space by pioneering yield farming (which we will go deeper on in a second), which kicked off the DeFi summer of 2020, which launched DeFi into being the most promising crypto application as of today. In a push to decentralize the Compound protocol, the creators decided to distribute governance tokens to the protocol's users. The tokens were given to users as a yield for depositing assets in the protocol to either lend or borrow, and from there allow users to create and vote on proposals to make changes to Compound. This method became incredibly popular and today it is common practice for DeFi protocols to have governance tokens that are distributed to users of the protocol. For example, Maker has MKR tokens and Aave has AAVE tokens that are distributed and used in the same manner.
Generating Yield
As we just discussed with Compound, this system made “yield farming”, as it has come to be known, incredibly popular. This is because now a potential lender does not only receive the yield from the people that are borrowing, they also receive yield from the protocol for supplying it with what it needs to function. For a borrower it allows them to earn yield for taking out a loan, a notion that simply didn’t exist previously.
There are several layers of risk and reward when it comes to yield farming as it pertains to lending & borrowing. Those looking to play it safe could deposit stablecoins on a protocol like the ones above that are established and enjoy APYs that are much better than the banks plus get paid in governance tokens on top. On the other hand, users could elect to supply liquidity on up and coming protocols that are in much greater need of funds and are supplying a much higher amount of their native tokens to incentivize people. The risk in this however is that not only are less mainstream projects likely to be hacked, there is the potential for the market to be manipulated much easier when the pool is smaller.
When it comes to lending and borrowing in specific, the amount you make is based on the supply and demand like we talked about earlier. If you are providing liquidity to a money market that has lots of supply but not as much demand, you will likely receive a low interest rate. However if you supply liquidity to a money market that has low supply but high demand you will likely get a high interest rate. Besides being necessary to make the whole thing work, this mechanism creates efficiency of capital because it matches supply and demand through incentives. The reason one market versus another would have higher demand and supply largely depends on market conditions. For example in a bull market most people don’t want to be stuck holding stablecoins, they want the upside of ETH or altcoins. Inversely during a bear market people are much more welcoming of holding stablecoins compared to the alternatives.
Risks
Anywhere that you find the potential of great rewards you can be sure that there are going to be risks, whether you see them easily or not, and lending and borrowing with DeFi is no different. While many people have come to the conclusion that the rewards of using DeFi compared to TradFi greatly outweigh the risks, that doesn’t mean they don’t exist.
The most prominent risk when using any DeFi application is the smart contracts being exploited. With billions of dollars being held in open source code that is surely going to attract many hackers and that is indeed the case with DeFi. Developers go to great lengths to audit their code but we have seen several significant hacks in DeFi already and we will surely see more going forward. This is a big part of the risk profile of using smaller protocols with higher rewards compared to the ones mentioned above. Smaller protocols have not had the kind of battle testing that bigger ones have, as if there were potential flaws with main services on Maker, Compound or Aave they likely would have been exploited already. That is not to say however that it is impossible that one of those protocols gets hacked going forward, especially as new code is written on changes to the protocol.
Another risk to borrowing and lending with DeFi revolves around the fact that loans are not fixed rate as we discussed earlier. While it is unlikely that interest rates will change rapidly, an event that causes the market circumstances to change can cause it to happen. Most notably this happened in 2020 with DeFi summer, when borrowing APYs on some coins shot to over 40%.
Hopefully this has given you a good idea of how lending and borrowing works in DeFi, and who the main players are. Lending and borrowing is a foundational layer of DeFi and will only grow in years to come. To put things in perspective, the TVL of the three platforms mentioned above is about $35 Billion. Compare that with the global bond market which is $128 Trillion and you realize just how early we are…
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⚠️ DISCLAIMER: Investing into cryptocurrency and DeFi platforms comes with inherent risk including technical risk, human error, platform failure and more. At certain points throughout this post, we might get commission for promoting certain projects, if this is the case we will always make sure it is clear. We are strictly an educational content platform, nothing we offer is financial advice. We are not professionals or licensed advisors.
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