Similar to DEXs, decentralized lending is also one of the key components of DeFi. If the DeFi Summer of 2020 was fueled by competition among various DEXs, triggering a liquidity race, then the integration of Compound lending and DEXs marks the prologue of an exciting trend.
In the traditional financial system, users are required to have a bank account and complete identity verification to access financial services. For activities like lending, substantial personal and collateral information need to be provided, and the process involves multiple layers of scrutiny, making it a cumbersome procedure.
For Decentralized Finance (DeFi) services, anyone who can provide collateral can complete lending without the need to disclose information to third parties. Borrowers can obtain loans by collateralizing their cryptocurrency assets and paying interest, while lenders can deposit their assets on the platform to earn interest.
The core of DeFi's ability to operate without the need for approval lies in the use of smart contracts to facilitate lending relationships. All lending conditions are encoded into smart contracts in advance, and once the conditions are met, the lending relationship between the parties is automatically executed within the contract. This eliminates the need for third-party maintenance and management.
Decentralized lending has shattered the numerous barriers present in traditional finance. On one hand, it has increased the utilization of cryptocurrency assets, and on the other hand, it allows more users to generate passive income by holding cryptocurrencies. This phenomenon has been a key driver behind the explosive growth of DeFi and the advancement of the cryptocurrency world.
Currently, DeFi's main lending methods can be categorized into the following three types:
In the lending process, both parties place orders on the platform, and the platform acts as a matchmaker. Additionally, in cases where the borrower is unable to repay on time, the platform automatically initiates the liquidation process. Platforms like dYdX and dharma offer these types of services. Peer-to-peer models require matchmaking, which can result in relatively lower efficiency.
One of the most well-known platforms in this model is Maker, built on the Ethereum blockchain. On Maker, users can deposit ETH to borrow a stablecoin called DAI, which is pegged to the US dollar. The platform requires the collateral ratio to be maintained at 150% or higher.
A distinctive feature of Maker is that the interest rate is determined through voting by MKR token holders. However, due to this decentralized governance approach, the interest rate can be quite volatile. For example, it once went from 2.5% to 19.5% in just over a month.
This is currently the most mainstream DeFi lending and borrowing model on the market. Two major platforms, Compound and Aave, both utilize this model.
The liquidity pool trading model is more akin to traditional banking lending methods. Users can deposit and withdraw as needed, pooling funds from lenders in a liquid funding pool. As long as there's enough capital in the pool, borrowers can access funds at any time. The system uses algorithms to balance supply and demand and sets interest rates.
Compound
Compound allows any user to deposit assets into the platform's liquidity pool. The design of the Proof-of-stake token mechanism has also been widely adopted in the industry. When users provide assets, they receive cTokens from Compound as proof of ownership. The exchange rate of cTokens is determined by the interest of the assets, and over time, their value increases. Deposit users only need to hold cTokens to automatically earn interest.
Aave
Aave is also a lending protocol platform based on the liquidity pool model. Users can deposit assets at any time to earn interest or lend out another type of asset. In addition to this, Aave introduced a pioneering product in the DeFi space known as "flash loans," which are uncollateralized loans.
Flash loans allow borrowing without the need for any collateral, with the condition that the loan and repayment, including the interest payment, must be completed within a single Ethereum block (15 seconds). If the operations are not completed within the block, the smart contract cancels all previous actions to ensure the overall protocol and asset safety.
Flash loans are particularly useful for arbitrage traders, as they provide capital efficiency for conducting arbitrage trades across various DeFi Dapps.
Maker
Maker is one of the earliest DeFi lending protocols. It allows users to create DAI by over-collateralizing tokens, enabling over-collateralized loans. Currently, Maker supports over 30 different tokens for collateralization. DAI is a decentralized stablecoin pegged to the US dollar. In addition to being a lending protocol, Maker also serves as the issuer of the stablecoin DAI.
With the introduction of the various models above, we have gained a foundational understanding of decentralized finance (DeFi) products. However, have you ever wondered how DeFi ensures the safety of both lenders and platforms, given the non-custodial and efficient nature of fund movement in the DeFi space?
Due to the absence of traditional credit indicators in DeFi, the core principle of all major platforms is over-collateralization. This is enforced through smart contracts, which implement strict liquidation processes.
Over-collateralization helps mitigate default risks to some extent. For example, if a borrower takes out 100 USDT, the platform might require them to pledge at least 150 USDT worth of ETH as collateral. If the value of the collateral drops to 100 USDT, the borrower needs to deposit more collateral, or the smart contract may sell the collateral to protect the lender's assets. Actual platforms might have even stricter measures, such as issuing reminders for collateral top-ups or initiating partial liquidation when the collateral value falls below 120 USDT.
However, the high volatility of cryptocurrencies brings its own risks. Although the probability of rapid crashes is small, in the event of a black swan event, it could still impact the security of DeFi platforms. Additionally, there have been instances of assets being stolen from DeFi platforms due to contract vulnerabilities. Therefore, while users can enjoy the flexibility and convenience of DeFi, they should also pay attention to proper fund management to safeguard their principal, as there is a possibility of losing both interest gains and the initial investment.
Decentralized finance (DeFi) revolutionizes lending and borrowing through smart contracts, eliminating the need for third-party verification. This significantly lowers the entry barriers for users. Moreover, the DeFi space continues to evolve with innovative lending models emerging, such as leveraged lending, which can further enhance capital utilization. The DeFi lending market holds immense potential for the future, and as it progresses, there is room for significant growth and innovation.
Certainly, we must also acknowledge the existing issues in lending within the DeFi ecosystem. Many lending protocols still rely on over-collateralization, which leads to inefficient capital usage. Undercollateralized loans are likely the next direction for the development of DeFi lending protocols. Offering loans with less collateral can enhance the capital efficiency of DeFi lending protocols and compete effectively with traditional lenders.