Borrowing and Lending-The Edge of DeFi over Traditional Finance

Borrowing and Lending-The Edge of DeFi over Traditional Finance

In the last few years, DeFi protocols have caused a significant paradigm shift in the world of finance. Virtually every existing financial model has been replicated and even improved on using blockchain technology. Borrowing and lending are some of the many models that decentralized finance has re-invented.

Borrowing and lending have been existing since way back. While this financial model has done a lot of good for individuals and organizations alike, a lot can still be improved on. The DeFi models that exist today seek to fine-tune the existing structure for borrowing and lending. Its main goal is to make borrowing seamless and incentivize lenders for contributing to pools

Working Principles of DeFi Loans

The DeFi loan ecosystem rewards contributors or lenders using a smart contract. The smart contract is decentralized and access can be granted to anyone who can contribute to the pool. Crypto assets held in a wallet can appreciate over time. However, these assets do not appreciate in quantity.

A user who purchased 1 ETH for $600 will still have 1 ETH when the price appreciates to $4000. However, a lender who disburses 1 ETH may have 1.1 ETH at the end of the year for a pool that gives a 10% APY. Thus, lenders can gain from the rise in the value of a crypto asset as well as interests from lending this asset. This added incentive motivates lenders to contribute to borrowing and lending pools.

A smart contract built on supporting blockchains like the Ethereum blockchain enables borrowing and lending to go on smoothly on the platform. Loan pools automatically stick to the written code of the smart contract and disburse returns to lenders at the right time.

Like the traditional finance model, borrowers will need to deposit collateral in most cases before a loan can be disbursed. The downside of this requirement is that the collateral of a borrower is usually greater than the value of tokens a borrower wishes to obtain. However, this ensures that the volatility of crypto assets at the time a deposit is made does not harm the lender.

The Edge DeFi protocols over Traditional Banks

Without any doubt, the traditional finance model for borrowing and lending has done a lot of good to the financial system and economy of many countries. However, this model still has some shortcomings which DeFi protocols solve.

  • Lender Protection: In traditional finance models, borrowers sometimes exploit lenders and avoid repayments when due. The DeFi model for borrowing and lending ensures that borrowers do not default. Since the penalty for failing to keep up to an agreement is usually severe, borrowers try to reimburse funds on or before the due date. In most cases, borrowers who fail to do this end up losing their collateral which is more than the amount borrowed. This ensures that the lender gets back his asset, either as a yielded return or valuable collateral.
  • Higher Returns: The banking and finance system as well as other similar finance structures usually set up incentives for individuals who store their funds for some time. However, these incentives are relatively low. DeFi protocols on the other hand reward users with higher returns. Some pools have an annual percentage yield as high as 100% yearly. The higher incentive for lenders on DeFi platforms has attracted investors to make deposits in the pool.
  • Unrestricted Access to Funds: DeFi protocols provide users with a financial system in which restrictions are reduced. Since the model is decentralized, anyone, regardless of age, financial background, occupation, and race can borrow funds from lending pools. This is not the case with traditional finance models which place a significant measure of restrictions on borrowers. Users using a smart contract must still abide by the rules of the protocol.
  • Protection Security: Traditional finance models usually require as many details from users who wish to obtain loans from the system. While this is done to avoid individuals from defaulting on their agreements, it can tint the reputation of an individual and expose personal details a person may otherwise wish to conceal. DeFi protocols on the other hand do not intrude on the privacy of users. Loans can be obtained without harvesting a bulk of data from the borrower or even the lender as the case may be.
  • Potential Price Appreciation on assets: In the real world, a lot of assets and items that can be used as collateral either depreciate over time or are illiquid. This is not the case for most crypto assets. In the long run, genuine crypto assets appreciate over the years and serve as a better store of value. Additionally, tokens deposited as collateral by borrowers are highly liquid. This implies that they can be easily exchanged for fiat or other crypto assets. This makes the DeFi world suitable for long-term investors and borrowers.

There are multiple platforms for borrowing and lending in the DeFi ecosystem. Each platform has its unique features. Some of the popular platforms include Aave, Maker, InstaDapp, Compound, and Liquidity.

In terms of Liquidity, Aave is the leading DeFi platform with over $18 billion locked in its lending pools. MakerDAO comes close with a TVL of 17 billion. Just like many other lending protocols, Maker’s smart contract was built on the Ethereum blockchain.  InstaDapp boasts of a TVL of over $12 billion while Compound follows closely with a TVL of $11 billion. Liquidity on the other hand sits far below with a TVL of $2.2 billion.

Conclusion

Borrowing and lending in decentralized finance is a relatively new concept. At the moment, both lenders and borrowers benefit from the existing DeFi smart contract structures. However, more can still be done to aid borrowing from pools. Additionally, the security of smart contracts can be compromised by hackers.

Several times, flash loans have been used to siphon funds from lending pools. It is expected that in the coming years, all or most of these drawdowns will be fixed, and many users will effortlessly use DeFi models over brick and mortar financial structures.