What is DeFi Borrowing?

A Primer for One of the Most Popular Practices in DeFi

What is DeFi Borrowing?

Financial freedom and inclusivity have been hot issues for many years. Nonetheless, it took Bitcoin to popularize the weird concept that a decentralized computer network can produce sound money.

And just as Bitcoin raised the possibility of money without a central bank, Ethereum has developed borrowing without the involvement of commercial banks. Alongside decentralized exchanges, borrowing dApps have generated $5B in revenue at the end of 2022.

Streamlined Borrowing Processes

So how does DeFi borrowing work?

While a number of digital “neo-banks” have streamlined the borrowing process in the last decade, most customers have to pass through a painstaking process to receive a loan. The reason is simple: the lender wants to make sure a borrower is worth the risk of default.

  • Customers have to verify their identity
  • Customers have to undergo credit history financial checks
  • Customers may have to talk to a lending agent to get approval
  • Customers may have to wait for the loan to be approved

Few of these TradFi hurdles are present in DeFi because decentralized applications are hosted on a public blockchain; they can be accessed without permission, credit history, and ID verification.

Anyone with internet access can borrow assets permissionlessly, without talking to anyone. Those are the upsides of DeFi over TradFi. Nevertheless, there are some downsides to automated lending:

  • A traditional bank can issue unsecured or uncolletarlized loans based on criteria such as credit history, profession, and income, in addition to collateral. In DeFi, collateral must always be present to borrow money and often must be over-collateralized as a safety net against debt liquidations and crypto’s volatility.
  • Because banks are regulated by the government, they typically insure customer funds up to a threshold. For example, in the U.S., the Federal Deposit Insurance Corporation (FDIC) insures depositors in registered banks up to $250,000. Although there are decentralized insurance solutions in DeFi as well, they are still incipient.

How Does DeFi Borrowing Work?

Everything in decentralized finance is governed by smart contracts. Just as digital banking has largely replaced branches and tellers, smart contracts automate any activity that can be logically or legally defined.

In turn, these smart contracts are embedded on a public blockchain, making them public and subject to scrutiny.

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Here is how DeFi borrowing works:

  1. Developers program smart contract logic to govern the conditions under which a loan is taken. Smart contracts exist on a blockchain, offered to users via a user-friendly interface — dApps.
  2. Users themselves (lenders) provide liquidity to make borrowing possible. Called liquidity providers (LPs), they deposit their funds into smart contracts called liquidity pools. LPs are incentivized to do so because they receive a cut whenever borrowers tap into these pools to borrow digital money.
  3. Borrowers only interact with the liquidity pools themselves, not other users that poured liquidity in them. Likewise, because there is no human involvement but just computer logic, there is no such thing as an unsecured loan in DeFi.
  4. Depending on the type of deposited collateral for a loan, borrowers face different collateral ratios. For example, stablecoins are exempt from crypto volatility, so they are most used as a capital-efficient collateral.

After the borrower picks the type of digital asset for the collateral, they see how much collateralization is required, in addition to picking either variable or fixed interest rate. This annual percentage yield (APY) goes to liquidity providers, making them take the role of private banks.

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All lending/borrowing dApps are accessible with a non-custodial wallet such as MetaMask, which is conveniently integrated into a web browser. When visiting any lending dApp, the user then simply connects their wallet, which has to be funded to deposit a collateral for a loan.

Unlike banks, the team behind the DeFi platform itself typically earns only a tiny portion of the revenue through fees. They themselves can be tweaked at any moment by the community thanks to the platform’s governance token.

Source: The Block, Cryptofees

For example, Aave, as one of the most popular borrowing dApps, has a governance token AAVE, which grants users voting rights on the development of the platform and as a liquidity booster against debt risk.

DeFi Borrowing Limitations and Risks

Outside of lacking the possibility of unsecured loans, DeFi’s decentralization can also become a drawback. Because these lending platforms entirely depend on other users to provide liquidity, it may happen there is not enough liquidity to go around.

As a result, there is often an upper limit to the size of loans that can be taken. Additionally, users have to pick carefully what type of asset they wish to use as a deposited collateral. For example, despite Ether (ETH) being the second largest cryptocurrency, its value on a weekly basis is still volatile compared to a fiat currency.

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This is no good when using it as a collateral because each smart contract has a liquidation threshold. For example, if ETH has a LTV (loan-to-value) percentage of 80%, this means that to loan 80 ETH, the borrower must deposit 100 ETH as a collateral. With these different LTV ratios, smart contracts give borrowers a liquidation leeway, in case the value of the collateral significantly goes down compared to the value of the loan.

Stablecoins lack such price volatility, which is why their LTV percentage is often above 90%. For this reason, stablecoins are the most used asset for DeFi borrowing, as we can see from one of the more popular lending dApps — Compound.

Source: The Block, Compound Finance

Once the LTV threshold is breached, the borrower’s collateral gets automatically liquidated, no questions asked because there is no human around to ask them. The moment the borrower takes a collateralized debt position (CDP), their funds are locked in a smart contract, released only when the loan is repaid.

We have already seen what a massive loan liquidation event looks like when Terra’s UST algorithmic stablecoin depegged from the dollar in May 2022. Terra’s main lending dApp, Anchor Protocol had $1.32B worth of liquidations.

Source: Parsec, Flipside

To mitigate the liquidation risk of their collateral, borrowers will not only use stablecoins, but also borrow less than they can to leave themselves extra breathing room.

Which Are the Most Popular Borrowing dApps?

Due to their decentralized nature, lending dApps with the highest liquidity tend to be the most popular. This snowball effect is similar to Twitter getting social media dominance despite there being dozens of other apps with the same functionality.

The top five most popular dApps to get anonymous loans are the following:

  • Aave – very flexible platform with deep liquidity and the widest collateral type diversity
  • Compound – sets interest rates on loans algorithmically, depending on available liquidity
  • Liquity – borrowing with zero interest rate due to the unique dual tokenomics
  • MakerDAO (Oasis) – Using DAI stablecoin, as a multi-collateralized asset.
  • Alchemix – novelty of self-repaying loans that mitigates liquidation risk.

In this early stage of DeFi, many users stick with the most popular dApps because they are the most vetted by code audits. Likewise, they are more resistant to rug pulls, which happens when whales (high net accounts) drain the platform’s liquidity, as happened with Terra.

Series Disclaimer:

This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.

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