Lending crypto in the decentralized finance world can earn someone decent interest compared to centralized financial entities. But there are risks to beware of.
While the concept of financial ‘lending’ has been around for eons, DeFi lending is a recent innovation and operates through the DeFi lending platform or DeFi protocols that offer cryptocurrency loans in a trustless manner.
Unlike the regular financial ecosystem, the DeFi space operates without any third part of central authority. DeFi lending allows the holders to stake their coins in the DeFi lending platforms for lending purposes and earn interests without intermediaries.
DeFi or Decentralized Finance is an ecosystem of financial applications built on top of blockchain technology. The DeFi ecosystem started on the Ethereum network and is built on self-executing smart contracts that don’t require a third-party intermediary. It relies on a peer-to-peer network to establish decentralized applications, assets, and protocols that provide a range of financial services and features similar to those offered by conventional banks and financial middlemen.
Read on to get a closer look at how DeFi lending works and how it has pushed Finance in a new direction.
How Does DeFi Lending Work
DeFi lending enables traders to volunteer their cryptocurrencies for lending purposes on the platform without a central authority having access to their data. It allows transparent and straightforward access to assets from anywhere in the world for every financial transaction without interference from a third party.
DeFi has the maximum lending growth rate and offers lending benefits to both lenders and borrowers. It also provides margin trading opportunities, allowing long-term investors to lend their assets while earning higher interest rates.
These Defi protocols allow users to borrow loans at decreased rates. Users can exchange fiat money for cryptocurrency on centralized exchanges and then lend it on a decentralized exchange.
Defi Lending Platforms
When utilizing DeFi protocols like Aave, users interested in becoming “lenders” need to transfer their funds into what is known as a “money market” using a smart contract, after which the tokens become available for borrowing to other users.
Crypto financing allows investors to borrow cash or crypto assets by mortgaging their crypto holdings as collateral. The lender maintains ownership of the assets when using crypto lending. However, the crypto provided as collateral cannot be moved during the loan period.
The process is relatively simple and is described below:
- Users lend cryptocurrency, usually stablecoins, to a lending platform to earn interest without paperwork.
- Contact is made with the lending platform, and a loan is requested by a borrower.
- The borrower warrants cryptocurrency as insurance for the loan. The loan is then accepted, and the crypto platform attaches the collateral. The borrower must repay the total amount before taking back the collateral fund.
- To maintain the collateral’s value over the value of the loans, the platform can liquidate the users’ loan into stablecoins if their collateral drops below a particular range.
Below are some of the most popular DeFi lending platforms:
Launched in 2020, Aave is an open-source Ethereum based non-custodial DeFi lending protocol that allows its users to borrow assets while simultaneously earning interests on the assets they have to proffer to the protocol. The DeFi protocol enables lenders to accumulate assets in a pool, and an equivalent amount of tokens is received in return.
Algorithmically Aave adjusts the interest rates on crypto-assets according to the protocol’s demand and supply. The interest rate you earn through fund deposits may balance out the interest rate users accumulate by borrowing.
With a total value of $18.44B and several tests and audits conducted by third parties, Aave is considered one of the topmost secure DeFi protocols, earning a security score of 95.
Maker is a unique Ethereum based DeFi lending platform that issues only the DAI token, a stablecoin pegged with a $1. Maker has a secondary token, MKR. Token holders can vote on issues of governance, such as mending the stability fee and alternative risk parameters.
Maker is open to anyone creating a vault to deposit collaterals like USDC, ETC, or other assets and reproduce DAI against the collateral.
With its total value notched at $15.74B and a security score of 85, Maker is one of the most secure platforms.
Compound is an Ethereum based autonomous algorithmic DeFi lending application that utilizes a money market approach within the cryptocurrency world. It allows anyone to deposit assets into community liquidity pools and start trading and compiling interest without a fixed duration for a loan.
Compound has a total value of $15.74B and is considered a secure platform with a security rating of 95.
Alchemix is a loan-based Ethereum DeFi platform that utilizes a new method in which loans are paid back automatically over time. In exchange for depositing DAI into a smart contract, a token is given to the user, representing the deposit’s potential future yield.
You can access all these DeFi platforms through a CoinStats Wallet, your gateway to DeFi, allowing you to sell, swap, buy, loan, earn, and track all your digital assets from a single location.
DeFi Lending Rates
The most significant advantage DeFi lending has over traditional financial lending is allowing its users to earn high-interest rates, with earnings ranging between 5% and 15% APY (Annual percentage yield).
Earning Protocol Fees
DeFi protocols charge modest fees for activities like the lending, swapping, and borrowing of assets. Several DeFi projects allocate a portion of the fees they earn to other users in exchange for providing liquidity.
Data from CoinStats shows the interest rates and fees on different protocols. Today, Aave, Compound, and Uniswap are amongst the highest earners based on Ethereum.
Gas fees or transactional fees are dues developers levy to process transactions on the Ethereum blockchain- where the majority of DeFi transactions occur.
In June 2020, the total gas fee needed to execute a transaction on Ethereum was equal to $0.45, while in September, it saw an increase of 2,686%, making the new charge $12.54
In the last quadrant of the year, there was a drop in fees due to slowing activity, but on January 4, 2021, $17.56 was recorded as the average gas fee per transaction, the highest price recorded so far.
The Ethereum yellow paper imposes that every transaction attracts a minimum of 21,000 Gas, which most platforms then adopt as their set default limit. A user must set a gas ‘limit’ and gas ‘used.’ The interrelation of these two will regulate the price – the higher your gas limit is, the faster your transactions will be processed.
DeFi Lending Risks
It’s right to assume that DeFi lending offers one of the most reliable and attractive approaches to earning passive income, with significantly higher interest rates compared to traditional financial institutions. However, as with any financial institution, there are several risks involved.
Here are the three most significant risks everyone should know before lending crypto assets:
You risk “impermanent loss” when investing your assets in a liquidity pool.
Impermanent loss occurs when the assets an investor locks in a liquidity pool change price after being deposited. This creates a loss as opposed to simply holding assets in a crypto wallet by the liquidity provider.
The risk of impairment loss relies heavily on the Automated Market Maker system used by popular liquidity pools. DeFi pools have to maintain a ratio of assets of two tokens. For example, an ETH/LINK pool may have a fixed ratio of 1:50 respectively, so anyone wishing to offer liquidity in the pool would have to deposit both Ether and Link in the same ratio.
Flash loans are a new generation of loans that don’t require collateral. Flash loans utilize smart contracts to mitigate the risk associated with unsecured loans.
However, borrowers are required to repay the full loan borrowed back in the same transaction, usually within a couple of seconds. The transaction is rolled back if the borrower fails to pay back the loan.
DeFi Rug-pulls is a new type of exit scam in decentralized Finance.
DeFi platforms don’t have regulations like traditional financial systems, and the users’ trust in the platforms they choose to trade their assets on is usually breached through Rug-pulls.
A new cryptocurrency is created by developers and paired with a prominent cryptocurrency like Ether, and then a liquidity pool is set up. People are encouraged to deposit their assets into the pool with promises of a high-interest yield. After extensive marketing carried on the newly created token, the pool gains a substantial amount of the leading cryptocurrency.
Back doors that are intentionally coded into the token’s smart contract are then used to mint millions of new coins and then sell the popular cryptocurrency.
This act drains the top cryptocurrency in the pool, thereby leaving millions of worthless coins in it and the developers disappearing without a trace. A famous example of Rug-pull risks is when in 2020, the SushiSwap founder Chief Nomi liquidated his SUSHI tokens after gathering collateral worth more than a billion dollars.
How to Avoid DeFi Lending Threats
Despite the increase in financial scams, there are several steps you can undertake to investigate the risks before investing in a lending platform.
We have summed them up for you:
Step #1: Verify the team’s integrity on other projects.
Step #2: Carefully read through the project’s whitepaper.
Step #3: Check if a third party has audited the project’s code.
Step #4: Be conscious of red flags, like non-realistic interest rates, over-the-top promotions, and marketing strategies.
DeFi lending is a genuinely captivating technology with the capacity of reshaping the world’s financial system. It attempts to decentralize the foundation of traditional financial services like trading, investments, lending, borrowing, and insurance.
As the first global financial system shaped by its very population, Decentralized Financial lending has created new prospects for the financial world with giant strides in financial possibilities.