The progressive adaptation of DeFi blockchain technology is aiding the finance sector enormously. The DeFi applications are pacing ahead to replace fiat currencies with cryptocurrencies and crypto finance instruments in the near future. In this scheme of things, DeFi Loans aren’t too far from attracting the attention of interested users.
The DeFi market has grown over $20 billion from the previous year’s $1 billion market cap. That’s an explosive 19,900% growth! Such advancement of the DeFi systems is projected to only boost further by the emergence of various DeFi Lending solutions.
To precisely understand how DeFi Loans work & which DeFi Lending Platforms are best, let’s first familiarize ourselves with the basics.
Read More: DeFi Ecosystem Basics
What is DeFi Lending?
The DeFi Loans involve acquiring crypto loans as a borrower who could obtain them from a Crypto Lending platform. The DeFi Crypto lending platforms can allow these loans without an intermediary, making them trustless crypto loans.
Such loans have a P2P model where other users can enlist their crypto tokens for loans, which earns them interest. Currently, using the crypto tokens this way can be highly rewarding than merely holding them in wallets.
How does DeFi Lending work?
Decentralized Applications (DApps) play an essential role in making and facilitating the DeFi Crypto Loans. Fundamentally, the DApps are created using smart contracts on the blockchain, and they perform coded automated functions. Depending on their creation, the DApps functions can be transactional or non-transactional to assist a particular action on the blockchain.
Hence, DeFi DApps can help anyone become a lender by allowing them to accrue interest on their lent crypt coins. Such crypto tokens from various lenders will form a crypto lending pool that can be of different types. Naturally, the different lending pools will assimilate different types of interest to lenders and subsequently different borrowing methods for borrowers.
Also, since traditional financial loans rely on collateral to be seized in the scenario of failing to return the loan, DeFi loans follow a similar rule. The DeFi loan borrower must offer collateral that should be something of greater value than the crypto loan.
For instance, a borrower seeking the loan of 1 Bitcoin will have to offer a crypto coin(s) equivalent to its value. If the need to secure the collateral arises, created smart contracts can secure the collateral crypto coins automatically.
Types of DeFi Crypto Loans
Because various types of Crypto coins exist with multiple use cases, DeFi Crypto Loans can be of numerous types. Moreover, obtaining any of them can be similar, with the principle of offering collateral being constant, for the most part.
Following are the different types of DeFi loans available across various DeFi Lending Platforms:
- Rate Switching
- Uncollateralized loans
- Flash Loans
- DAI Loans
- Crypto Security Loans
- And so on…
Eight Benefits of DeFi Loans
DeFi loans can exponentially increase the market cap of crypto exchange by imparting the following types of benefits:
1. Quicker Loan Processing
Lending a loan via a wholly digital & automated medium like smart contracts zeroes the loan application approval time. Such contracts can be configured to calculate & recognize the lending terms and associated risks before confirming a crypto loan application.
2. Lending Consistency
Because the norms of lending are created with smart contracts, they all will have identical valuation parameters. Such functions result in delivering concrete results by reducing the need for studying applicants & deal attributes in isolation or individually.
3. Better Interest Rates
Instead of limiting the market supply by hoarding the crypto coins, users can pool them for DeFi loans to grow their circulation. In turn, this activity increases the value of the said cryptocurrency and lending, which will naturally offer better interest rates.
For comparison, lending fiat money will not generate you a growing sum of interest because its value is centrally regulated.
4. Transparency & Compliance
Since each transaction is recorded on the blockchain ledger and employs the user verification system, the whole exchange is transparent. Only verified accounts can be borrowers and lenders, and every transaction detail & norms will be recorded, serving as exchange evidence.
Such services make the DeFi loan system significantly more compliant to follow a governing body’s existing finance exchange rules.
5. Better Analytics
Acquiring the lending market analytics to study demands becomes easier with automated and configurable smart contracts. Because all the information is ever-present and accessible while being tamper-safe, such analytics can help form absolute data-driven credit policies.
6. Crypto Lending & Borrowing Flexibility
Any verified user owning a recognized crypto wallet can independently access DeFi loans. It serves to negate any geographic limitations & minimum capital requirements on becoming a lender or borrower.
Moreover, lenders can pool cryptocurrency on multiple DeFi Loan platforms, while borrowers can indulge in acquiring multiple DeFi loans.
7. Securely Customizable
Smart Contracts can be configured to accommodate various financial instruments with any set of norm attributes as per requirements. Such customizability can constitute the development of newer digital assets and multi-channel automated transactions between users & platforms.
Also, since smart contracts operate on Blockchains, neither can be manipulated by users or the platform after their creation.
Read More: How is Blockchain the most Secure Network?
One more excellent benefit of obtaining or lending DeFi loans is that they are run based on protocols & DApps. These can be explicitly coded to enable cross-platform DeFi loans integration, similar to how NFTs are traded across different platforms.
DeFi Loans Challenges
Crypto coin pricing fluctuations create some challenges along with other aspects of the cryptocurrency in DeFi loans. These challenges make the DeFi loans seem risky on the surface, except those can be steered conveniently with special arrangements.
Borrowers are required to deposit collateral against their DeFi loans, which can be as high or higher than 200%. When these collaterals begin to decline in their value, the platform holding them will employ circuit breakers, effectively liquidating collaterals.
In such cases, although the borrower bears a loss, they get to keep the loaned DeFi coins. Meaning, when the borrowers have certainty of the value of a cryptocurrency to rise, they might take a DeFi loan. The loaned crypto coin, whose value, when it increases, will then be sold.
Such practices can earn borrowers engaging in these practices with a rewarding sum against their DeFi loan.
-> DeFi Pullouts
Any DeFi Loan platform has to establish itself trustworthy in the marketplace to attract lenders whose accumulation can attract borrowers. After accomplishing this, the DeFi developers will form a new crypto token that will pair with a mass-circulation cryptocurrency.
Creating a new lending pool in this manner will become grounds to encourage people to make deposits. After pooling a significant share of mass-circulation cryptocurrencies, the deliberately coded back doors into the paired new crypto token will let them mint more new coins. Such new coins will then be sold against the mass-circulation cryptocurrency. It will result in effectively removing popular cryptocurrencies from the pool and leaving behind millions of insignificant coins.
In this manner, the DeFi platform will disappear from the market without a trace and cause a DeFi upset.
-> Flash Loan Market Manipulations
The process of obtaining crypto loans against zero collateral is available on the DeFi space. But, it can effectively be manipulated despite having flash loan smart contracts to extenuate the risk.
Smart contracts programmed for flash loans can facilitate the lending of large sums of crypto money. In the event of failure to pay back the lent sum in the duration, the lender can retract the loan automatically via smart contracts.
However, the borrower can use the lent amount to manipulate other crypto assets despite such a recollection mechanism.
For instance, suppose a person buys XYZ cryptocurrency in large quantities with their DeFi loan. Thereon, they dump it into the open market, effectively causing the price of the XYZ coins to crash. Such practices rarely cause such coins to recover in price.
-> Impermanent Losses
Returning to the previous scenario, what happens when collateral within a liquidity pool loses its value? It creates an impermanent loss situation.
DeFi pools have to maintain a ratio of assets in the pool, which also helps to keep it stabilized. It is performed by pairing the popular token with another token in a say 1:50 ratio. Anyone wanting to offer liquidity will have to therefore make deposits on both tokens in that ratio.
Now, when the value of the linked token declines in the market, traders will be incentivized to add the popular tokens and remove the linked ones. While this changes the ratio of coins, it is stabilized by increasing the cost of the token in higher supply and vice versa.
After such rebalance, the liquidity pool value becomes lesser than the value of assets held by the lending protocol. This phenomenon is essentially called Impermanent loss.
Role of DeFi Loans in the Crypto Finance Services Sector
The DeFi Loans can constitute multiple finance mechanisms into a singular model to help the financial service sector.
+ Asset Management
DeFi lending presents the users possessing crypto wallets to become owners of crypto assets that can securely interact with DApps. Using such Decentralized Apps, users can perform purchasing, selling, lending, or borrowing crypto assets activities that can earn them interest.
Savings without earning is pointless, so DeFi platforms offer different ways to manage savings for users. The crypto investment placed in interest-bearing crypto accounts can maximize the earnings, bringing more profit than traditional savings accounts. Examples of popular crypto savings DApps include PoolTogether, Argent, etc.
+ Crypto Monetary Circulation
The activity of Peer to Peer (P2P) lending and borrowing of crypto assets via DeFi lending applications & protocols ensure circulation. It can help grow the crypto asset value that would otherwise sit dormant in a typical crypto wallet.
Best DeFi Lending Platforms
Now that we’re better acquainted with the Defi Lending ecosystem let’s look at some prominent DeFi Lending Platforms. These platforms have already established billions of dollars in market capitalization and are on the rise, assuring DeFi loans growth.
The non-custodial, decentralized liquidity market protocol is open source and built on Ethereum. It allows users to earn interest on investment deposits and asset borrowing and welcomes both borrowers and lenders.
Lenders who pool cryptocurrency into the protocol are provided with aTokens of an equivalent sum, and it regulates interest rates based on the demand and supply. The greater the aTokens are held by users, the greater interests they will earn.
It only allows for borrowing DAI tokens, a stable coin with its value attached to the USD. Anyone can access Maker to own a vault that stores collaterals like BAT or ETH tokens to generate DAI as debt. Such arrangements encourage users to participate in operational earnings via governing fees which is the interest rate on the network.
In the scenario when the vault value declines below the fixed-rate, it corrects it by levying a 13% penalty followed by liquidation to stabilize the vault value. The liquidated collateral is then sold to the market at a 3% discount. Should the vault value continue to decline, Maker’s token MKR is minted and sold in the open market, therefore diluting MKR holders.
The platform runs on an automated money market protocol using smart contracts, allowing users to lend crypto assets and earn interest on it. Borrowers can obtain other crypto assets against their collateral, and it supports MetaMask.
Its COMP tokens allow users to own voting rights over protocol decisions while their native cTokens are used for tracking positions. The nature of the latter tokens is ERC-20 standard, so when a user, say, deposits ETH, the amount is converted to cETH and so on. It supports lending and borrowing of tokens like BAT, USDC, ETH, DAI, etc.
It is one of the platforms without a limit regulation on token swapping, which allows exchanging ERC-20 & ETH tokens. Users can swap any ERC-20 tokens or pool them to earn a fee and have the ability to form new pools. Users can also deposit their crypto tokens into existing pools to avail themselves of better fees.
Future of DeFi Loans Lending
The evolving market of Defi Systems is accentuating the crypto market and crypto asset management. The introduction of more such systems will become available sooner after an immensely sporadic and massively successful growth observed within the previous year. All in all, it can present borrowers to earn more DeFi loans for lenders to unlock better interest rates.