DeFi lending is broken down step by step. We talk about how to make the most lending to decentralized protocols.
In decentralized finance, or DeFi, lending is significantly more accessible than in traditional finance. Lending refers to giving your assets to other users who want to borrow them. On the other side of lending is borrowing, which refers to borrowing assets.
DeFi lending is a model of decentralized finance that allows users to borrow and lend both stable and volatile currencies and other assets. These include assets like Bitcoin, Ethereum, and USDC. One of the benefits of DeFi lending is that it removes the need for middlemen who handle the borrowing process. This article will cover the basics of DeFi lending and some strategies you can use to get started.
Often times different lending platforms will have their own native token. This token serves a lot of purposes with the protocol and can be programmed to do unique things. Mainly voting power, which can be very powerful to rally against your own agenda, and control the protocol itself.
This token will often have a rewards system or scheme to it where it will reward liquidity providers in a certain way to give it a price. This price will help improve the rewards a person sees, and will oftentimes pay out more than the underlying real yield itself. This is not necessarily an awful thing to happen, but this constant sell pressure from these APYs does lead to problems over time.
Some smart investors are pricing this in as dilution similar to a traditional equity entity. This chart below was originally made by Mechanism Capital
In finance, lending means giving money to someone or an organization in the hopes that they will pay it back, plus a fee. Borrowing, on the other hand, is receiving money from a person or an organization, usually for a specific purpose, and then paying it back over time. There are a few reasons you would want to do this, but in general, it's because you want to buy something that you cannot pay for in full right now. A real-world analogy would be taking out a loan to buy a house or car.
When you lend in the real world, you provide the borrower the funds and hope they will pay you back with interest.
Banks and lenders must "hope" that loans will be repaid because defaulting is technically an option. However, in DeFi, lenders are essentially guaranteed a return on their investment.
This assurance is possible in DeFi because loans are "overcollateralized." Overcollateralization means that to receive a loan, borrowers must provide collateral worth more than the loan's value. For example, if a borrower wishes to borrow $10,000, they must provide another crypto asset such as Bitcoin or Ethereum in order to receive the loan. The value of the asset they provide must be worth more than the asset they borrow.
The amount of collateral provided vs the amount borrowed gives us the collateralization ratio. Therefore, If someone borrows $10,000 of USDC against $30,000 of BTC as collateral, their collateralization ratio would be 300%. In other words, the collateral they provide is worth 300% of the borrowed assets.
Collateralization refers to the dollar amount of assets the borrower puts up to borrow your assets. In the previous example, if a borrower puts up $30,000 of BTC to hold onto while they borrow $10,000 of USDC, that means their collateral ratio is 300%. Therefore, this would be a very safe loan because their asset would have to decline 66% (or $20,000) before it would be in danger of being liquidated.
On decentralized borrowing platforms, the platform automatically ensures your investment is safe by taking advantage of collateralization ratios. When a borrower takes out assets, their loan is overcollateralized. However, due to the volatile nature of crypto, their loan can become undercollateralized if their collateral falls in price or the asset they borrow increases in price.
This is why borrowing platforms such as MakerDAO or Aave use collateralization ratios to ensure your investment is safe. If the collateralization ratio drops below a pre-determined thresshold, the collateral gets sold and the lender is made whole. This process ensures that the lender is always made whole even if the borrower does not repay their loan.
For example, imagine you depositing $10,000 of USDC into a lending protocol (such as MakerDAO or Aave). A borrower comes along and gives the protocol $5000 of BTC as collateral and borrows $2500 USDC. After a week, the value of the provided BTC is now just $2750. The collateral would not longer be valuable enough to secure the loan, but would still be more valuable than the loan.
In this case, the protocol will take the borrower's collateral, sell it for $2750, and repay the balance of $2500 plus any interest earned. Then, whatever is left over is returned to the borrower. In this case, it would be $250 minus any additional penalties for getting liquidated.
Lending in DeFi is one of the safest ways to earn interest on your assets. The interest rate is not very high, but the risks are much lower when compared to other types of loans. Interest rates of 1-3% are not uncommon for assets like Ethereum, and rates around 4-6% are common for stablecoins like USDT and USDC. If you are risk averse but still want to earn interest, DeFi lending is among the best moves you can make. Because the lending platform manages your assets for you, you will never have to worry about losing money on your loan. One other reason you may choose to lend is that you want to borrow! To borrow, you will need to lend assets worth more than the amount you are borrowing.
Borrowing in DeFi is a great way to access your funds without selling your assets. For example, if you own $500,000 in BTC, you cannot buy a car with your BTC unless you sell it. If you sell your BTC to buy a car, and the price of BTC goes up, you will miss out on the appreciation. In most countries, you will also need to pay taxes on the BTC you sold.
However, using your BTC to borrow another asset allows you to keep the BTC and also avoid taxable events. If you are using Compound, for example, you can borrow USDC from them after putting your BTC up as collateral, and then spend that USDC without selling your BTC. Borrowing, therefore, allows you to spend your money, while still keeping your investment in BTC.
You may also choose to borrow because you want to buy more assets. If you own BTC and want to buy ETH, you can deposit your BTC, borrow USDC, and then buy ETH with that USDC. This way, you still have the BTC to benefit from any appreciation and have increased your available capital for ETH.
Be warned, though; this also increases your leverage. In this case, since you own both BTC and borrowed ETH, if the prices go up, you will make more money than if you just held BTC. Similarly, if prices fall severely, you can lose your entire balance since you have to pay back your USDC loan, even if the ETH you bought depreciates.
If you want to generate a steady, reliable yield with relatively little risk, lending crypto could be a good option. This is not an investment that will typically ‘go to the moon,’ but because it is low-risk, it can be a good part of a balanced portfolio. It also allows you to generate a small yield on assets that would otherwise be sitting idle, not earning anything.
To get started with lending, check out platforms like Aave and MakerDAO or newer platforms like Radiant Capital, Benqi, and Compound.