Why borrow and lend in DeFi?

Most people are familiar with the concept of borrowing and lending whether it be in the form of mortgages, student loans or similar etc. Indeed, it is one of the core aspects of the financial system. Lenders provide borrowers with funds with the expectation that the borrowed amount is paid back with additional interest for providing immediate access to funds.

Traditionally the process of bringing borrowers and lenders together was facilitated by financial institutions such as banks or peer-to-peer lenders who control access along with borrowing lending rates. In traditional financial markets, the market for short-term borrowing and lending is referred to as the money markets. In the CeFi (centralised finance) crypto space this is done by centralized platforms such as BlockFi, Celsius etc. Much in the same way banks work, these CeFi platforms take custody of depositor’s assets and in exchange pay a low (but safer) rate of return. With the deposited assets they lend out to other parties typically institutional players such as hedge funds, market makers (with lower chance of default) etc.

DeFi borrowing and lending offers innovations in efficiency, access and transparency compared to CeFi. In contrast to traditional banks and CeFi platforms mentioned above, DeFi allows any users to become a borrower and lender without having to hand over personal information, identity or undergo KYC (know your customer) procedures. Borrowers and lenders also do not have to hand over custody of funds (i.e. user has access to their funds at all times). This is done through smart contracts on open-source blockchains predominantly Ethereum. Lenders can deposit to a lending protocol and borrowers will borrow from that protocol. At any time lenders can redeem the deposited assets and borrows can pay back part or all of their debt.

So how does borrowing and lending in DeFi work?

Users who want to become lenders can deposit their coins into DeFi protocol-based smart contracts. In return they will get newly minted tokens native to the protocol e.g. aTokens for Aave, cTokens for Compound, Dai for MakerDao. These tokens represent principal and interest in token form that can be redeemed at any time. The rate of exchange between the native tokens and the tokens deposited embeds inside the APY (annual percentage yield) i.e. an interest rate determined by the ratio that exists between the supplied and borrowed tokens in a particular market.

Borrowers can choose to borrow from one of these protocols and put down collateral. An important part of these type of loans is that they are over-collateralised. This means borrowers deposit as collateral an amount in crypto more than they borrow. Whilst the incentive to do this might seem counter-intuitive, reasons include borrowing to cover unforeseen expenses, avoiding forced liquidation of crypto holdings that are anticipated to appreciate, leveraging exposure on a crypto asset for speculation purposes and avoiding capital gains tax.

One might ask is there a limit to how much can be borrowed. The answer is yes and this borrowing cap is determined by two factors. First is the amount deposited by lenders in the protocol’s funding pool. Second is the quality or “collateral factor” of the coins put down as collateral by the borrower. The higher the quality of collateral the higher the amount can be borrowed e.g. if ETH has a 75% collateral factor and 10 ETH is put down as collateral, the borrower can borrow an amount in cypto worth up to 7.5 ETH. Borrowers can put down several different coins as deposit each with differing collateral factors. The limit the user can borrow will then be the total sum of these coins amounts multiplied by the collateral factor. Typically, users will borrow less than their limit and leave a buffer as the prices of tokens can fluctuate and can cause borrowers to be suddenly caught out borrowing an amount more than their limit. Thus, it is prudent to monitor when to deposit more collateral or maintain a healthy buffer because if the limit is breached, the collateral will be auto-liquidated by the protocol typically at a hefty discount to pay back the loan. The price feed to value token prices (which determine limits and collateral values) in these scenarios depends on the protocol. Compound uses a blended feed of reputable crypto exchanges whereas Aave relies on using Chainlink as its price Oracle.

In addition, Aave offers stable APY which can be considered fixed in the short-term but can still change to adapt in cases of extreme liquidity changes, and in the long-term to changes to the supply and demand ratio between tokens. Another innovation Aave offers are flash loans. These are loans that are do not require collateral and the borrower uses the funds and repays the funds in the same on-chain transaction (in case of non-repayment all transactions including the loan are reversed). This innovation is an efficient solution that can be used for instantaneous arbitrage, portfolio restructuring and refinancing.

Despite the potential innovations that borrowing and lending in DeFi offers, there are also risks that come along with it. Smart contract risk whereby the protocol’s public code is targeted by hackers looking to exploit bugs and benefit from malpractice is a common form of attack in DeFi. Also users can be exposed to more volatile changes in APY e.g. in the DeFI craze of 2020, some borrowers were caught out by big increases in their as some cryptocurrencies rose 40%. Another risk to be aware of is that users need to be extra cautious with wallets and addresses, etc. Sending money to the wrong wallet or losing your private key means that your funds are lost forever, which is not likely to occur under the protection that traditional banking provides.

References:

Lending and Borrowing in DeFi Explained – Aave, Compound. Finematics YouTube video

DeFi lending and borrowing, explained. Cointelegraph

DeFi and the Future of Finance, Forthcoming August 2021, Book by Ashwin Ramachandran, Campbell Harvey, and Joey Santoro