How do DeFi lending platforms work?

Lending is one of the most important aspects of liquidity, which is the foundation of most cryptocurrency markets and exchanges. One could say that it is the lifeblood of the crypto money flow, as it creates liquidity with which cryptocurrency exchanges can operate. Without lending, the trading of different cryptocurrency pairs could mean very high slippage and fees, and certain small markets and exchanges could eventually dry up. 

Traditionally, “lending” is processed by brick-and-mortar banks, institutional lenders, P2P lenders and other money markets. Lenders earn by receiving interest in return for lending their capital to borrowers. Financial institutions have lending products, such as certificates of deposits (CDs), repurchase agreements (Repos), commercial papers, treasury bills (T-Bills), and money market mutual funds. 

You may not even know it, but if you have money deposited in a savings account at a bank, you typically earn a very small annual interest, because technically you are considered a “lender” and as such, you can earn money on your deposited funds. 

In the cryptocurrency space, “lending” can be facilitated through CeFi (centralized finance) and DeFi (decentralized finance) protocols.  The former involves lending your cryptocurrency to CeFi platforms, sometimes called “crypto banks.” The downside of doing this is that they will have full custody of your crypto assets for the entire duration of the lending program, and you have to fill out a KYC (know-your-customer) application. As such, it defeats the entire essence of crypto being decentralized, and furthermore, you are more susceptible to hacking, inside jobs and bad loans. 

This is the reason why most people turn to the latter as a more convenient and safe way to “lend.” Through DeFi protocols, people are able to lend out their cryptocurrency assets without the need to submit a KYC form or surrender custody of their tokens. Practically, anyone with a crypto wallet can participate in DeFi lending and borrowing – it’s that easy. 

DeFi protocols are able to create money market funds similar to the way traditional financial institutions do, but it is purely digital, permissionless and automated. People who want to participate in this field need to log into these DeFi platforms and supply their tokens in exchange for interest. This interest, also called APY (annual percentage yield), is usually computed automatically by an algorithm. 

The entire process of lending happens without human intervention; everything is built upon the blockchain through algorithm-based smart contracts, which makes them transparent to everyone. As soon as you lend your tokens through the DeFi platform and the smart contracts, the other side of the process gets into gear simultaneously, as borrowers are now able to access both the supply tokens and the interest for their own use. 

How to use digital currency as collateral?

DeFi platforms enable you to use your existing digital currency, like Ethereum (ETH), as collateral for taking out a loan. Why would you want to do that? Well, for example, you are bullish long-term in Ethereum (ETH) and you do not want to sell your existing position, but you would also like to participate and trade high-flying tokens in the short term. You can use your Ethereum (ETH) as collateral in exchange for borrowing other tokens. This way, you keep your collateralized Ethereum, and at the same time, you have funds for other tokens as well. 

It is also noteworthy that potential borrowers of any cryptocurrency in a DeFi platform are required to supply collateral before they are able to borrow tokens. The value of the collateral is always higher than the amount to be borrowed. This concept prevents bad loans, to ensure that borrowers repay what they have borrowed, because the underlying collateral is of higher value than the tokens they have borrowed.

What is crypto loan liquidation?

However, due to the volatility in the cryptocurrency markets, it is entirely possible that the value of the collateral may drop lower than the borrowed amount over time. When this happens, you may be susceptible to what is called “crypto loan liquidation.”

When borrowing crypto-backed capital, it is mandatory for the borrower to give a collateral amount higher than the value of the crypto loan. As long as the value of the collateral is higher than the loan amount, the loan term is usually unlimited. However, once the liquidation price of your crypto loan has been breached to the downside, due to market volatility, a flash crash, a bearish market or any other reason, your loan will be liquidated at the liquidation rate, to ensure all expenses relating to the loan are paid. 

Always keep tabs on liquidation rates when taking out a crypto-backed loan. You can prevent liquidation from happening by depositing more funds as collateral to accommodate the liquidation price, or just by repaying the loan amount, plus the interest. 

What are the best Decentralized lending platforms?

Here are the top DeFi lending platforms as of 2021:

• Aave Protocol (AAVE) 

The Aave Protocol is an Ethereum-based lending platform that is completely decentralized. Through the smart contracts algorithm built upon the blockchain, users are able to efficiently lend their crypto assets and earn interest on them. At $2.33billion, their native token, AAVE, is currently the 57th-largest cryptocurrency in terms of market cap. 

• Maker Protocol (MKR)

This is one of the earliest DeFi platforms, which focuses on managing the largest stablecoins on the cryptocurrency market, namely the DAI. Users can earn interest through their savings rate contract, by locking in their DAI tokens, which are pegged to the US dollar. Maker’s governance token, MKR, allows holders to vote on adding new collateral assets to the protocol, changing the risk parameters of collaterals, changing the DAI savings rate and other upgrades. 

• Compound Finance (COMP)

Compound Finance is a lending protocol that was launched in September 2018. Users can participate in their open lending platform by depositing their Ethereum tokens and earning interest. Their native token, COMP, is the 83rd-largest cryptocurrency, with a market cap of $1.179 Billion. It is also a governance token, which means that if you hold the token, you can vote to implement changes in the protocol – this could be the adjustment of collateralization levels or other policy changes.