Today, thanks to Blockchain and smart contracts, you can get a loan in a matter of minutes by paying a deposit, and after repaying the loan, you can get your deposit again, and all this process is done without intermediaries and completely digitally.
It is difficult to imagine a financial system without lending and borrowing, and decentralized finance, or DeFi for short, is no exception. 2020 was a year full of innovations for lending and borrowing digital assets in the field of defense, and many decentralized lending platforms have successfully established themselves in this space. Given the importance of this concept in the digital currency industry, continue using an essay From the Coin Telegraph website, we have an overview of the lending and borrowing process in the field of decentralized finance and some details of this popular field.
Lending and borrowing
Lending, both in the area of traditional finance and in the field of digital currencies, involves the provision of monetary assets (whether digital currencies or national currencies) by one party to another in exchange for fixed profits and income.
The concept of “lending and borrowing” has existed for a long time and is one of the main aspects of any financial system. This concept is of particular importance in the current world financial system, which is based on the “fractional banking” system. The mechanism of this system is very simple: lenders make certain assets available to borrowers in exchange for regular interest rates. Traditionally, financial institutions, such as banks or independent entities such as peer-to-peer lenders, are responsible for this process, but in the world of digital currencies, this is somewhat different.
In the field of digital currencies, lending and borrowing can be done in two main ways:
- Through centralized financial institutions such as BlockFi and Celsius
- Using decentralized protocols such as Compound.finance, Aave.com and Makerdao.com
To get a loan in decentralized protocols, all you have to do is install a Metamask wallet on your computer browser, have some ether or other collateral in it, and visit the website of one of the above platforms. After checking the required interest and collateral, you can easily get a loan by providing collateral. Of course, this also has risks that you will continue to read.
Centralized financial institutions active in the field of digital currencies can be considered as a subset of Centralized Finance (CeFi). CeFi platforms, although somewhat decentralized, still operate in the same way as traditional banks. In fact, Safai platforms are a bridge between the traditional banking system and emerging digital assets. These platforms take over the management of individuals’ deposited assets, lending them to third parties such as marketers, hedge funds or other users of their platform, and on the other hand, making a fixed profit to the initial depositor. This model may seem very interesting and practical in theory; But the truth is that it is extremely vulnerable to problems such as theft, hacking and abuse by infiltrators.
In the face of centralized finance, we are dealing with the Decentralized Finance industry (DeFi for short), which differs in many ways from its centralized type. DeFi protocols allow users to use lending services in a completely decentralized manner and have complete control over their assets. This is possible by using intelligent contracts that run on blocks of free space such as Ethereum. Unlike Safai, anyone anywhere in the world can use Defy platforms and do not need to provide personal and identity information to a central management to use it.
Lending and borrowing on defy platforms
To lend and borrow on Defy platforms, the lender first uses a smart contract to send the tokens they want to lend to a virtual place called the “money market”. The lender’s profit is also given to him in the same market and in the form of native platform tokens.
So the first step for users who want to lend their assets on these platforms is to send this asset to the money market. We explained that the money market is actually a smart contract that acts as an automated digital intermediary. This digital intermediary converts users’ assets into coins that are made available to loan applicants.
The smart contract automatically offers interest-bearing tokens to the lender in several stages. The lender can later replace these tokens with their original assets. The tokens that are generated are native tokens of the platform. For example, interest tokens on the Avi platform are called aToken, and on the maker platform, they are called Dai.
Almost all loans offered through indigenous tokens are overpaid. In other words, users wishing to receive a loan must provide a guarantee in the form of digital currencies that are worth more than the original loan amount.
This condition may seem trivial at first, because you might think that a person can sell his property from the beginning to get the money he needs. But as you become more familiar with Diffie platforms, you will realize that there are many logical reasons for this.
The first reason is that users may not want to sell their capital, even if they face unforeseen costs; Because they are likely to increase the value of their assets in the future. In addition, by borrowing through defy protocols, individuals can potentially avoid or delay paying taxes on the capital gains of their digital tokens. Finally, individuals can leverage the assets they have borrowed through these platforms to increase their leverage in certain special trading situations.
The amount of credit that each user can receive is limited and there are two main factors that determine this limit:
- The first factor is the amount of capital available on the platform to borrow. This may not seem like a big deal; But if one intends to borrow a large amount of a particular token, this factor can be problematic.
- The second condition depends on the “collateral factor” (tokens) provided by the borrower. The term “collateral agent” refers to the total amount that can be received for the amount of collateral provided. For example, the collateral for Dye and Ether tokens on the Compound lending platform is 75%; This means that users can get a loan of up to 75% of the value of Dai or Ether they have provided.
From a more technical point of view, it can be said that the total value of the loan amount of the borrower should remain less than this amount: the value of the provided collateral multiplied by the collateral factor.
As long as this condition is met, the person can receive as much money as he wants.
How to distribute profits in Difai
In short, the function of lending platforms is that the lender chooses the coin he intends to lend in addition to the decentralized platform he wants to use and attaches his digital currency wallet to the desired platform to donate these coins. . The lender’s interest will then be sent to the same wallet.
The interest that lenders receive and what borrowers must pay is calculated using the ratio that exists between tokens offered and borrowed in a given market.
It is also worth noting that, depending on each market, the percentage of annual interest of borrowers (Borrow APY) is higher than the percentage of annual interest of borrowers (Supply APY). In other words, the interest that the borrower has to pay is greater than the interest that the lender receives.
If we want to take a slightly more specialized look, we can say that the interest on loans is determined per Ethereum block, and therefore, this amount is generally variable. Users’ percentage of profit varies dramatically at different times depending on the demand for a particular token. Of course, today some protocols, including AVI, set a fixed interest rate for the borrower.
Therefore, each platform may offer different benefits depending on its terms and conditions.
Defy loan risk
Defy protocols also have their own risks, among which we can mention the following three:
- Manipulation of smart contract by a third party
- Loss of collateral due to a sharp drop in price (for example, more than 50%)
- Raising the borrower’s interest rate in a short period of time
It should be noted, however, that these risks are really small compared to centralized finance. However, like any other financial process, the field of defense is not without risk and has its own problems.
For example, during the Diffie Madness era in 2020, when the “Yield farming” method gained much popularity around the world, borrower interest rates for some digital currencies rose by more than 40 percent. This may cause novice and ignorant users who do not follow their loan interest rates on a daily basis to be forced to repay more interest than they originally expected.
Overall, although the whole process of lending and borrowing using DIFI platforms is not really complicated, these platforms differ in some details (such as supported wallets and interest rates).
The larger the platform used and the more liquid it is, the less risk there is.
In addition, their users should be careful and when entering their wallet address, make sure that they enter the details and numbers correctly so as not to lose their assets in the end; Because then there will be no way to recover these assets.