Think of a financial system where you can transact with anyone, anywhere without any third parties or restrictions whatsoever. This is exactly what DeFi is i.e. decentralized finance. This financial system is based on blockchain technology, which aims to create a trustless, permissionless, transparent and open-source financial service ecosystem that is available to everyone and is fully decentralized, thereby means it is not under the control of any central authority. The users would take advantage of a P2P interface or decentralized applications (DApps) for maintaining complete control over their assets and interacting with the ecosystem.
The building blocks of decentralized finance are smart contracts, which are transaction protocols or computer programs that automatically control, execute, and enforce the transactional agreement between the participants involved in DeFi transactions. The applications of DeFi were initiated by Ethereum, and most of the decentralized finance applications that exist are based on Ethereum. Therefore, most tokens in the system are known as ERC-20 tokens. There are a slew of advantages of DeFi as compared to the traditional finance system. The former gives easy access to financial services and doesn’t have any restrictions.
There is no central authority involved, which means the presence of arbitrators and intermediaries is eliminated, thereby reducing the transaction fee. Furthermore, DeFi’s lending option is beneficial because it is easily accessible and can be used for making a profit.
What is DeFi Lending?
A platform where borrowers can meet lenders in a trustless manner is what DeFi lending is all about. There are no arbitrators and intermediaries involved and it provides crypto owners with the option of putting their tokens into lending pools. Anyone who is interested in borrowing will be paired to the lender directly in a P2P interface. Anytime a user wants to lend their crypto tokens on a DeFi lending platform, they are added to a lending pool where they can be accessed by a borrower. The lender and the borrower are linked together by smart contracts.
The best thing about this form of lending is that it offers anonymity to both parties because there is no physical property that’s used as collateral, as is in the case of the traditional financial system. The borrower is required to deposit almost the same value of the token that they wish to borrow. For instance, if you are interested in borrowing 10 Bitcoins from the lending pool, then you will be required to deposit the equivalent of these tokens in DAI.
When you want to pay back your loan, you are also required to pay 10% to the lending pool. The DAI you initially deposited will be returned to you and the 10% Bitcoin is given to the pool of investors who participated in the lending process.
DeFi Lending Vs Traditional Lending
So far, decentralizing finance has provided a number of solutions for problems that exist in traditional finance systems, such as security, centralization, and more. However, there are some complexities that have also surfaced, such as a lack of liquidity. There is no denying that in some areas, DeFi lending has some major advantages over traditional lending, but there are other areas where it has its own difficulties.
DeFi lending makes use of a blockchain-based network for conducting its transactions, which means the entire process is devoid of any arbitrators, third parties or central authority. This makes DeFi lending seamless, smooth, and exclusively between the lender and borrower. In comparison, traditional lending involves an intermediary, which is the bank in most cases. The decentralized nature of DeFi lending is one of its biggest advantages, but it does come with a few cons. As the process is decentralized, it means that there is absolutely no need for identification, paperwork, or KYC, which makes it susceptible to money laundering and other such illegal activities.
Collateral representation is an area where DeFi lending trumps the traditional form of lending. Collateral is a major requirement of the traditional financial system, which should have physical properties. There is no such requirement that you will have to deal with in DeFi lending because it involves depositing tokens in the DeFi protocols that are then used as collateral. But, the problem with the collateral required by DeFi lending platforms is that it is on the high side.
For instance, MakerDAO, a DeFi lending platform, requires borrowers to place a collateral that is around 150% in value of the loan you request. However, investors are drawn to the fact that the value of this collateral can also rise. For instance, if you have deposited 1 Bitcoin as collateral for a loan, it is possible that the value of BTC may increase in the duration of the loan. When you get the collateral back, the value is now higher, which means you have made a profit during this process.
You can get a DeFi loan with just an internet connection, a decentralized finance wallet and by opening a smart contract.
Top DeFi Lending Platforms
There are a number of DeFi lending platforms that have been established so far and some of the top ones include:
- Aave: Founded in 2017, Aave was initially known as ETHLend and it enables users to borrow and lend a diverse range of cryptocurrencies using variable and stable interest rates. A flash loan system is used by this DeFi lending platform, which means that you don’t need to have collateral for requesting a loan. The system relies on the loan’s repayment timings.
- Compound.Finance: Like most DeFi Lending platforms, Compound.Finance is a system of accessible smart contracts based on Ethereum. It was founded in 2018 by Robert Leshner. Its native token called cToken is used for allowing users to make money while also using it for making transactions on the app, thereby making it different from the other DeFi lending platforms out there.
- Maker: People can only borrow DAI tokens via this DeFi lending platform and only BAT and ETH token trades are allowed for now. MKR has introduced ‘governance fees’ which work as interest rates for the network.