DeFi lending, borrowing explained

In Guides

From the inception of capitalism, banks have played a significant role in the economy. These centralized financial institutions decided every step of the banking process. As a result, it has been a system susceptible to physical and digital security threats, market manipulation, discriminatory regulations for different social statuses, races, and ethnicities. 

Especially in lending and borrowing scenarios, it has been a significant disaster. Lending chunks of money to large corporations without having proper collaterals, giving air to bubbles, and all the things that can hurt the regular people. All of these things have severely disrupted the economy more than once. But what if we had a system that is decentralized in nature and has a prominent set of guidelines applied for all? 

Introducing DeFi or Decentralized Finance

A DeFi system is created to serve every person on Earth regardless of gender, caste, ethnicity, financial, or social status. Powered by Blockchain technology, DeFi works in a straightforward way that has made the process of lending and borrowing way easier and more effective. But how? Let’s understand it by comparing the two systems.

Traditional Banking System vs. Decentralized Finance

Say you need some emergency funds and decide to go to the bank to apply for a loan.  The bank will first review your application, check your credit score, credit card records, previous loans, assets and liabilities, income sources, and then decide whether to grant you the loan or not. If they do grant you the loan, getting a favorable interest rate is whole another thing. And the biggest problem? Only the bank can lend you the money, and you’re always the borrower. 

But DeFi puts you in a position where you’re eligible for both. You can borrow money from other people through a peer-to-peer network on a Decentralized Finance platform, or if you have some funds, you can lend them to people and earn steady commissions. All you need to have is a crypto wallet. In contrast to borrowing funds from a bank which can take from weeks to months, borrowing from a DeFi platform is a matter of seconds.

Also, you don’t need to provide any identity, KYC details, or anything of that sort. But what’s the catch? The only catch is, you need to have more money or asset available in collateral to take a loan of a certain amount.

Say you need 1000 ETH in loan, then you’ll have to submit 1001 ETH in collaterals. The general question is if I already have the money, why would I go for a loan? Before we answer the question, let’s understand how DeFi works. 

How Does DeFi Lending and Borrowing Work?

When borrowers apply for a loan, they select a pool in a DeFi platform in the simplest terms. The leading platform in DeFi, Aave, needs you to pay your collaterals in their local currency, aToken. So, if you’re paying 1001 ETH in collateral, you’ll have to convert the amount into aTokens. In general, the collateral is 150% or even 200% of the borrowed amount. 

When you take a home loan or a car loan, these assets are themselves collaterals. So, if you fail to pay up, they’re going the seize it from you. Since DeFi is obviously decentralized and works digitally, there is no physical property at stake here. You’re paying more money upfront than your loan amount to take out the loan.

During the loan tenure, if the price of your collateral asset starts sinking, the pool will employ its safety measures. As soon as the value reaches below 120%, it starts selling off your collateral. The only rule is — lose no money.

On the contrary, if everything goes well, the borrower comes back at the end of the loan tenure and pays the borrowed amount with 10% interest (this rate may vary). This interest is later divided into the pool among several lenders. 

Risk of DeFi

Decentralized Finance is still a very early phase. But managing over $80 billion in Total Locked Value, which was less than $10 billion a year ago, the market is maturing. Even though it contains some risk, DeFi’s flaws are negligible compared to the traditional banking system. 

Impermanent Loss

In layman’s terms, impermanent loss happens when the value of collaterals tanks causing trouble in the balance sheets. Even the pool liquidates the funds to mitigate losses; it destabilizes the whole system causing a moment of chaos in the pool. It often results in some loss. However, it’s not a significant threat, and calculated steps can avoid it.

Technical Vulnerabilities

Since the whole DeFi network is bound with hundreds and thousands of pages of codes, it’s possible that one flaw can disrupt the system. Whether due to outside penetration or an internal fault, problems with API, use cases, race conditions, exception handling, and I/O handling are always possible. 

Wrapping Up

Like any nascent, burgeoning industry, DeFi has its pros and cons. But being one of the fastest-growing services in the decentralized ecosystem, it’s moving forward fast. Whether Decentralized Finance replaces the traditional system or the traditional finance world adopts DeFi is a question for another time. Still, one thing is pretty straightforward — DeFi has the potential to claim the future. 

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