What is decentralized lending and borrowing?

Decentralized lending and borrowing, powered by DeFi protocols, provides an alternative to traditional lending by using smart contracts to facilitate loans. Decentralized finance (DeFi) aims to address the perceived inefficiencies and limitations of centralized financial systems by using blockchain technology to create a more open environment. With DeFi, users can lend or borrow digital assets without needing traditional intermediaries like banks.

Before taking out a traditional loan, borrowers must go through a number of mandatory steps so a financial institution can determine the likelihood they will default on their payments. Using traditional lending rails, a borrower has to qualify for a loan. Banks check potential borrowers' credit scores, which are based on an individual's borrowing and payment histories, total debt currently owed, and other factors. Forms often ask for personal information such as income and current assets that could be used as collateral.

Qualification is generally not a prerequisite in DeFi. Because loans are secured by smart contract automation, the process of lending and borrowing in DeFi protocols is trustless. The overcollateralization of loans is designed to ensure that the equivalent value of lent funds can be recovered by the lender, mitigating the concern of borrowers defaulting. In turn, borrowers do not have to go through an approval process, have their credit history checked, or reveal their income to secure a loan.

Another difference is how interest rates are determined. In DeFi protocols, rates are largely set by supply and demand for loans. When there are more lenders than borrowers, interest rates are often pushed down to attract more borrowing. Conversely, when there are more borrowers than lenders, rates may increase to make lending more attractive. Base rates may also be determined by a platform's community governance.

Lastly, in DeFi, users can directly act as the lender of their funds. Lending pool protocols allow crypto holders to generate rewards by lending their digital assets.

The lending pool model is a common form of lending and borrowing in DeFi. These protocols aggregate funds from many sources for borrowers, conceptualized as a peer-to-pool-to-peer structure. Lenders deposit crypto into a pool of assets, where borrowers take out those same assets and agree to pay them back with interest. The interest charged to borrowers is then divided among lenders to generate a reward.

Leveraged trading is another form of borrowing. In decentralized derivatives markets, crypto traders can use margin to increase their exposure to cryptocurrencies. In DeFi, this process relies on transparency, automation, and the overcollateralization of funds to account for price volatility.

In a standard mortgage, a borrower's asset is used as collateral to secure the loan. If a borrower can no longer make payments, the bank has the right to repossess the asset. Collateral is also necessary to secure certain loans in DeFi.

Some protocols set collateralization ratios that govern how borrowers secure their loans. If a user borrows $100 of crypto at a 150% collateralization ratio, they must always have $150 worth of assets or more locked up in the protocol's smart contract until the loan is repaid. Because these ratios require users to lock up more than the amount being borrowed, such loans are called overcollateralized.

However, overcollateralization can be complicated by the fluctuations in values of cryptocurrencies, so most borrowers choose to secure their loans with a cushion that exceeds the stated ratio. If the value of a borrower's collateral falls below the protocol's threshold, their funds get liquidated, and their assets are distributed to the platform's lenders.

A flash loan is the process by which a user borrows and repays a loan in one block through complex interactions with smart contracts. These unsecured, instantaneous loans are largely used to take advantage of arbitrage opportunities when two markets price an asset differently. In between the steps of borrowing and repaying the loan, a user sends the borrowed funds through one or more additional platforms to swap assets.

Decentralized lending and borrowing offers different features compared to traditional systems, including:

Permissionless access: Platforms are open to anyone with an internet connection and a compatible crypto wallet.

Transparency: Transactions are recorded on an open ledger, providing an auditable history.

Dynamic rates: Rates on DeFi platforms adjust dynamically based on real-time supply and demand.

Automation: Smart contracts help reduce the need for traditional intermediaries.

There are risks involved in the use of almost every financial tool. It is important to be familiar with the risks associated with decentralized lending before participating.

While in traditional finance, counterparty risk is mainly about the borrower defaulting, in DeFi, it involves platform risk and smart contract risk. Platform risk occurs when platforms might not be truly decentralized, potentially allowing owners to take control of deposited funds. Smart contract risk involves vulnerabilities in the code; hackers can exploit these bugs to drain assets from the platform.

Another major risk is impermanent loss, which affects users who provide liquidity to lending pools. This happens when the value of assets within the pool changes compared to if the user had simply held them in their wallet. The constant rebalancing of assets in the pool can sometimes lead to lower returns than just holding the assets. This loss is called impermanent because it is not realized until the assets are withdrawn.

Aave is a well-known lending and borrowing DeFi platform that uses a pool-based model for issuing loans built on smart contracts. Compound is another example of a money market that uses pools to connect lenders and borrowers. MakerDAO issues DAI, a stablecoin pegged to the US dollar, allowing users to deposit their crypto into Maker Vaults to collateralize loans in DAI. dYdX and Lighter are examples of derivatives markets where users can trade cryptocurrencies using margin.

Disclosures:

Content provided for educational purposes only. Not investment advice or a recommendation. Trading and owning digital assets involves significant risk, including the risk of substantial loss. Cryptocurrency services are offered through an account with Robinhood Crypto, LLC (NMLS ID 1702840). Robinhood Crypto is licensed to engage in virtual currency business activity by the New York State Department of Financial Services. Cryptocurrency held through Robinhood Crypto is not FDIC insured or SIPC protected.