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Decentralized Finance is seen by many to have numerous advantages over the traditional finance system, part of it due to DeFi’s unique lending system. In this guide, we’ll tell you all about DeFi Lending.
Imagine a financial system where you don’t need third parties, and you can transact with anyone anywhere, anytime without restrictions, yep! That’s DeFi. Decentralized Finance is a type of financial system that is built on blockchain technology.
The technology aims to create an open-source, permissionless, trustless, and transparent financial service ecosystem that is available to everyone and is completely decentralized (no central authority). The users would maintain full control over their assets and interact with this ecosystem via decentralized applications (DApps) or P2P interface.
Smart contracts are the building blocks of Decentralized Finance. Computer programs or transaction protocols automatically execute, control, and enforce the transactional agreement between parties in DeFi transactions. Ethereum initiated the applications of DeFi, and most DeFi applications are Ethereum based, making most tokens in the ecosystem, ERC-20 tokens.
DeFi has a sleuth of advantages over the traditional finance system. It offers easy access to financial services without restrictions. It is decentralized (no central authority). It has eliminated the presence of intermediaries or arbitrators, which would reduce the cost of transaction fees. Also, the lending option on DeFi is advantageous because it is easily accessible, and profit can be made using Decentralized Finance lending.
DeFi lending offers a platform where borrower meets lender on the platform in a trustless manner. That is, without intermediaries and arbitrators. It opens the possibility of crypto owners on the platform put their tokens in lending pools. A user who wants to borrow will then be directly paired to the lender in a P2P interface.
Whenever a user wants to lend out their cryptos on the DeFi lending platform, these tokens go to a lending pool where a borrower can access it. The smart contracts link both the lender and the borrower together.
Still, there is utmost anonymity with both parties, since, in this situation, there is no physical property to use as collateral like the traditional finance systems usually do. The borrower has to deposit at least the same value of the token they wish to borrow. For example, if you want to borrow 10 Bitcoin from the lending pools, then you will have to deposit the equivalent of 10 Bitcoin in DAI, which is 84,263.75 DAI.
After some time and you want to pay back the loan + 10%, you are required to pay in the lending pool, and then you will be given back the DAI you deposited initially, and the 10% Bitcoin goes to the pool of investors that partook in the lending process.
Decentralized Finance is unarguably the most valuable DApps in terms of locked cryptocurrency assets on the Ethereum based network, boasting a massive $8 billion in locked cryptocurrency assets of August 2020.
The DeFi has so far proffered solutions to the old issues facing traditional finance systems like centralization, security, etc. Still, it has given rise to new complexities like a lack of liquidity. We will examine some of the areas where DeFi has an advantage over traditional lending and some areas where it doesn’t.
Decentralized Finance lending utilizes a blockchain-based network for its transactions, making the whole process devoid of any central authority, third parties, or arbitrators. This makes DeFi lending smooth, seamless, and exclusively between the borrower and the lender instead of traditional lending, which has to be mediated by an intermediary (most cases the banks) and backed by arbitration.
The decentralized nature of DeFi lending is a big plus, but it has its disadvantages. The whole process is decentralized, and there is no need for paperwork, identification, or KYC, makes DeFi susceptible to money laundering practices.
An aspect that DeFi lending trumps traditional lending is in the area of collateral representation. The conventional finance lending system requires collateral in the form of physical properties. Most times, landed properties. Still, DeFi lending does not require physical properties as collateral; instead, tokens deposited in the DeFi protocols are used as collateral.
A downside to this is that sometimes the collateral needed by DeFi lending platforms is always an upside. For example, the DeFi lending platform, MakerDAO, requires borrowers to place collateral against their loans at a minimum of 150% of the value of the loan requested.
However, the fact that the value of the collateral could spike is a draw for investors. For example, when you deposit 1 Bitcoin (BTC) as collateral for a loan, the value of the Bitcoin you deposited could increase over the time of lending. When it’s time to collect back the collateral, the value would have increased, earning you a profit in the process.
All you need to get DeFi loans are an internet connection, a DeFi wallet, and to open a smart contract.
Several DeFi lending platforms are available; we’ll look at some of the popular Decentralized Finance lending platforms.
Aave is a type of DeFi lending protocol that enables users to lend and borrow a diverse range of cryptocurrencies using stable and variable interest rates. Launched initially as ETHLend, it was founded in 2017 by Stani Kulechov. The ETHLend ICO held in November 2017 raised $600,000 worth of Ether in exchange for 1 billion LEND tokens. ETHLend was later rebranded to Aave in September 2018.
A distinct feature of Aave is that it utilizes a Flash Loan system. This means that you don’t need to have collateral to request for loans on the platform. Instead of guaranteeing repayment with collateral, Flash Loans rely on the loan’s repayment timing. As long as the loan is used and paid back in full within the same block it was issued, it is approved. On the other hand, if the loan is not paid back within the same block, the entire transaction fails. Aave also offers flexible rates on the interest on lending.
To get started with Aave, you’ll need to visit their website and register using your web 3.0 token wallet.
Compound.finance, like most DeFi lending platforms, is a system of openly accessible smart contracts built on Ethereum. Robert Leshner founded it in 2018. It utilizes its native token, cToken, to allow users to earn money on their money while also using it for transactions on the application; this makes Compound.Finance different from other DeFi lending platforms.
Another distinct feature of Compound is that when the user’s funds are converted into ERC-20 tokens, they can be easily movable through other DApps. This ability to combine different protocols as building blocks represents a fundamental feature of the DeFi movement.
Compound is not decentralized, though, as the compound team currently manages the protocol. Still, the company has plans to achieve 100% decentralization by transferring all authority to a Decentralized Autonomous Organization (DAO) governed by the Compound community.
Maker is a DeFi lending platform that lets users borrow only DAI tokens. It currently allows only ETH and BAT token trades. MKR involves users in its operational earnings by introducing “governance fees,” which act as interest rates for the network. Users can keep their collateral in a core Maker smart contract called Collateralized Debt Position (CDP) to produce DAI.
Users interested in keeping up to date with Maker, weekly governance and risk calls are hosted every Thursday at 12 PM EST. Recaps of these calls are posted on Maker’s Youtube channel.
Decentralized Finance is well on its way to eclipsing the traditional finance system with some significant advantages like decentralizing its transactions, cutting transfer costs, and making lending easy and seamless. Decentralized Finance still has some downsides that might hinder its growth like technical and operational risks, the tendency for criminal practice to prevail, and so on. Still, one wouldn’t bet against DeFi completely taking over the financial world.