Decentralized Finance (DeFi) is the grouping of financial based blockchain applications that operate without any centralized control – such as a board, administration, or a third party. DeFi is the evolving peer-to-peer financial system that is open source, transparent, and permissionless.
Now onto lending. What is lending?
An individual or party loaning a sum of money to another individual or party. The recipient incurs a debt that will usually include interest on that debt until the principal amount borrowed is paid back in full.
Lending services are a huge part of the DeFi ecosystem. They essentially work in a very roundabout way. 1) A DeFi lending dApp or platform is launched with a set amount of liquidity or undergoes a funding round to begin. 2) Participants lend their money or crypto assets to the DeFi lending pool in order to earn interest. 3) Borrowers then obtain a loan by depositing crypto assets as collateral. 4) The loans are eventually paid back into the pool by the borrower along with interest. 5) The lender now receives the interest as well as the funds they originally deposited. 6) The cycle repeats.
The difference between traditional loans and DeFi loans
There are several drawbacks that come with traditional loans:
Limitation. Most traditional loans have strict limitations for what the funds can be used for. Further still, loan periods, maximum payback amounts, and raised interest are just a few things that corner borrowers into a very limited position.
Traditional loans always favour one party – the lender – which is usually a corporation or bank. This is usually constructed through high interest rates based on personal qualities that determine how much of a risk the loan is to the lender, putting the borrower at a disadvantage. These personal qualities are usually credit score, age, bank and payment history, among other things.
Traditional loans take time to execute because all of these details must be analyzed before determining the borrowers eligibility.
The benefits of DeFi loans:
Data is fully transparent on the blockchain which allows for enhanced, unbiased analytics. This also helps lenders and borrows in strategic decisions, predictions, and allocations through insights and can help build portfolios.
Participants own 100% custody of their assets and control their data.
Consistency in lending decisions is solely based on data and market value, eliminating individual variations and structured deals so that all participants are given an equal service.
The permissionless attribute of DeFi lending allows anyone with a crypto wallet access to DeFi lending apps regardless of funds, region, age, or credit history.
Programmability DeFi loans are a lot faster as they are executed on the spot and are backed by cloud computing services. Additionally, fraud identification software, powered by machine learning, on the blockchain prevents all suspicious or illegitimate behavior. Smart Contracts are responsible for the operational matters and are immutable, as they only execute transactions that are viable.
Interoperability benefits all participants as the DeFi ecosystem grows, creating a web of connected protocols and applications that complement each other and provide extensive value to everyone involved.
All processes – courtesy of smart contracts – automatically comply with federal, state, and local regulation, which guarantees the participant’s actions are legal.
DeFi Lending works!
A couple criticisms of DeFi that people frequently bring up are: ‘What happens if I simply don’t pay back the loan?’ And ‘What happens if my collateral drops in value?’
Any well-established or good DeFi platform will have mechanisms in place for any situation that could occur. For example, most DeFi apps require minimum collateral worth 150% of the borrowed amount, to protect the collateral from becoming less valuable than the original loan amount. In cases where the collateral does significantly lose value, or the loan amount isn’t returned, the borrower will be subject to a liquidation penalty.
DeFi protocols clearly work, as we’ve seen in recent times where centralized lending platform Celsius became overleveraged and was forced to liquidate. The DeFi protection protocols of AAVE and Compound forced Celsius to pay them back in full, which amounted to a total of $800 million in debt. No court or government’s law was involved in the process. Simply put, the DeFi code forced them to pay back their loans, proving its efficiency and reliability.