Decentralized Lending & Borrowing: A Complete Guide

Decentralized finance (DeFi) aims to address the inefficiencies and limitations of centralized financial systems by using blockchain technology to create a more open and accessible environment.

With DeFi, anyone can lend or borrow digital assets in a simple, transparent way, without needing intermediaries like banks.

How does it differ from the traditional banking system?

Before taking out a traditional loan, borrowers must go through a number of mandatory steps so a financial institution can determine the likelihood they will default (fail to make the required monthly payments). In other words, using traditional lending rails, you have to qualify for a loan.

First, banks check potential borrowers’ credit scores, which are based on an individual’s borrowing and payment histories, total debt currently owed, and a number of other factors. There are also forms that ask for personal information such as income and current assets—like a house—that could be used as collateral. Some loans may even require another person to co-sign with a borrower.

Qualification is not a prerequisite in DeFi. Because loans are secured by smart contract automation, the process of lending and borrowing in DeFi protocols is trustless. Lenders don’t have to worry about borrowers defaulting on the loan, because the over-collateralization of loans ensures that the equivalent value of lent funds can always be recovered by the lender. In turn, borrowers don’t have to go through an approval process, have their credit history checked, or reveal their income to secure a loan

Another difference is that interest rates for lending/borrowing in DeFi protocols are largely set by two factors:

1. Supply and demand for loans – When there are more lenders than borrowers in a system (high supply environments), interest rates are pushed down to attract more borrowing. Conversely, when there are more borrowers than lenders (high demand environments), rates are increased to make lending more attractive. Although this is true within a system, it is also a factor that affects cross- market participation, driving DeFi users to patronize one platform over another. This helps ensure that DeFi lending and borrowing is a maximally efficient market. While this also works in the world of traditional loans, DeFi makes this a much more efficient phenomenon. 2 Decentralized community governance – Base rates may be determined by a platform’s community governance, which can set a standard expectation and also be used to incentivize participation.

Lastly, in DeFi you can directly be the lender of your funds without a third party doing it for you. Lending pool protocols, a cornerstone of DeFi, allow any crypto holder to generate passive rewards by lending their digital assets. This means anyone can benefit from the opportunity to charge interest (that is, generate passive rewards) as loans are repaid by those who borrow your crypto.

How does decentralized lending and borrowing work?

Types of decentralized lending and borrowing

The lending pool model is the most common form of lending and borrowing in DeFi. Protocols that use lending pools to deepen liquidity by aggregating funds from many sources for borrowers. It can therefore be conceptualized as a “peer-to-pool-to-peer” lending structure. Lenders deposit crypto into a pool of assets, where borrowers take out those same assets and agree to pay them back with interest. The interest charged for all borrowers is then divided among all lenders to generate a stable reward.

Leveraged trading is another form of borrowing. In decentralized derivatives markets, like traditional finance, crypto traders can use margin to increase their exposure to cryptocurrencies with the goal of increasing their earnings. However, in DeFi, the process aims to be more efficient and fair thanks to its transparency and automation as well as the overcollateralization of funds to account for the sometimes-high volatility in price.

Collateralization

In a standard mortgage, a borrower’s assets (like a house, for example) are used as collateral to secure the loan. Therefore, if a borrower can no longer make payments, the bank has the right to repossess their house.

Collateral is also necessary to secure certain loans in DeFi.

Some protocols set collateralization ratios that govern how borrowers secure their loans. If a user borrows $100 of crypto at a 150% collateralization ratio, for example, they must always have $150 worth of assets or more locked up in the protocol’s smart contract—until they pay back the loan. Because these ratios require users to lock up more than the amount being borrowed, such loans are called overcollateralized.

However, overcollateralization can often be complicated by the fluctuations in values of cryptocurrencies, so most borrowers choose to secure their loans with a cushion that exceeds the stated collateralization ratio. If the value of a borrower’s collateral falls below the protocol’s threshold, their funds get liquidated, and their assets will be distributed to the platform’s lenders.

Flash loans

A flash loan is the process by which a user borrows and repays a loan in one block through complex computer code and interactions with smart contracts.

Before blockchain and DeFi, flash loans were not possible. These unsecured, instantaneous loans are largely used to take advantage of arbitrage opportunities when two markets price an asset differently. In between the steps of borrowing and repaying the loan, a user sends the borrowed funds through one or more additional platforms to swap assets, resulting in a quick profit.

Benefits of DeFi lending and borrowing

Decentralized lending and borrowing offers a range of advantages over traditional systems, including:

• Permissionless access: Platforms are open to anyone with an internet connection and a crypto wallet, and no KYC is needed to access them. This opens up financial opportunities to those who may be excluded from traditional banking.
• Transparency and immutability: Transactions are recorded on an open ledger (the blockchain), providing a permanent and auditable history.
• Potentially higher returns: Rates on DeFi lending platforms can be more competitive than those offered in traditional banking because rates can be optimized based on supply and demand dynamics in real-time.
• Faster and more efficient: Smart contracts automate the process which helps eliminate the need for intermediaries and helps reduce transaction times and fees.

Risks of DeFi lending and borrowing

There are risks involved in the use of almost every financial tool. Even holding cash comes with the risk of devaluation due to inflation. It's important to be familiar with the risks associated with decentralized lending and borrowing before you start.

One such risk is counterparty risk, where one party in an agreement fails to meet their obligations. While in traditional finance, a lender's counterparty risk is mainly about the borrower defaulting, in DeFi, it's more about the platform itself. This can take two forms:

• Platform risk: Some platforms might not be truly decentralized, allowing their owners to take control of deposited funds and disappear – a move known as a "rug pull."
• Smart contract risk: Smart contracts, while powerful, can have vulnerabilities. Hackers can exploit these bugs to drain assets from the platform, sometimes through sophisticated attacks like "flash loan attacks."

Another major risk is impermanent loss, which affects users who provide liquidity to lending pools. This happens when the value of your assets within the pool changes compared to if you had simply held them in your wallet. Essentially, the constant rebalancing of assets in the pool, driven by automated market makers and arbitrageurs, can sometimes lead to lower returns than just holding the assets. This loss is called "impermanent" because you don't actually experience it until you withdraw your assets from the pool.

Crypto lending and borrowing examples

• Aave is the prototypical lending and borrowing DeFi platform. It was one of the trailblazers of the pool-based model of issuing loans built on a system of smart contracts. It offers its services on multiple chains including Ethereum, Fantom, Avalanche, Polygon, and Arbitrum.
• ompound is another example of a money market that uses pools to connect lenders and borrowers. Like Aave, some of its most actively loaned assets are ETH, wrapped bitcoin (wBTC), and stablecoins.
• MakerDAO is the issuer of DAI, a stablecoin that is pegged to the US dollar. Users can deposit their crypto into Maker Vaults to collateralize loans in DAI. As the first crypto-collateralized stablecoin, MakerDAO’s DAI changed the landscape of DeFi when it was introduced in 2017.
• dYdX and Cap.finance are derivatives markets where users can trade cryptocurrencies using margin—a specific type of borrowing—for leverage.

Decentralized lending and borrowing essentials

• Decentralized lending and borrowing takes a familiar concept from traditional finance institutions and democratizes it using the tenets of DeFi and blockchain technology.
• Because of the trustless nature of DeFi, decentralized loans do not require evaluation of credit scores or other personal information, and interest rates are set solely by market participants rather than third-party institutions.
• The most popular model for decentralized lending and borrowing is through lending pools, which connect users through aggregate collections of digital assets; borrowers are required to overcollateralize the loans they take from these pools.