One of the blockchain’s major promises is to make tools used in the traditional financial sector accessible to everyone. Decentralized Finance (DeFi) is the term used to describe this revolution in how funds are spent, made, or sent.
Similar to traditional financial institutions, DeFi protocols also offer services like borrowing and lending but in a more decentralized manner. That means anyone can easily and quickly borrow a loan without disclosing their personal information to external parties or being subject to checks established by traditional banks.
In this article, we will discuss how DeFi loans work and their advantages over those offered in traditional finance.
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What is DeFi?
DeFi describes the process of importing traditional financial products, such as loans, into the blockchain. So through smart contracts, DeFi protocols are able to use cryptocurrencies to offer financial services.
On-chain data analysis platform DeFi Pulse indicates that as of April 2023, there is roughly $30 billion locked up in those protocols, up from about $1.3 billion in 2020. The two largest lenders at the moment are AAVE and Maker.
How Do DeFi Loans Work?
When your crypto sits in a Web3 wallet, it does not accrue interest. But thanks to DeFi loans, it is now possible to earn passive income in the form of interest by lending your crypto assets. That’s how traditional banks work, but they only give a few individuals access to this service. In the DeFi world, anyone can be a lender.
There are several ways to become a lender, but the main one is committing your crypto to lending pools.
What Makes DeFi So Special?
DeFi provides access to the same financial products available in traditional finance but with extra benefits. For example, since it’s anonymous and decentralized, it is easy for everyone around the world to access loans. Also, it makes it possible for anyone to earn interest by lending out their crypto to others.
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How Loans Are Made
Lending protocols use smart contracts to allow crypto users to lock up their assets and then loan them out to borrowers in accordance with the rules written into these contracts. Each lender distributes interest to investors differently. So before you commit your cryptocurrencies to any lending pool, it is important to do your due diligence.
How Do You Take Out a Loan?
If you wish to borrow a loan, you have to offer crypto assets that have equal or more value than the loan amount. For example, if you want to borrow two Bitcoin, you will be required to deposit the current price for two BTC in DAI. The DAI will serve as collateral.
After you repay the loan plus the interest, you will receive your DAI back. In that case, the lending pool is happy to earn interest and can now distribute it to investors, and you are also happy because you didn’t have to sell your DAI. This sound perfect; however, there are problems with the system.
By now, we all know that crypto assets are highly volatile, so what happens when the value of your collateral falls below the loan value? Borrowing from MakerDAO, for example, you will be required to collateralize your loan at 150% of the loan value. That means if you want to borrow 200 DAI, you will have to deposit a collateral of $300 in ETH. That said, your loan will be subject to a liquidation penalty if the collateral falls below the $300 ETH value.
Most lending pools have adopted this measure to ensure investors do not lose money. Therefore, you will suffer the loss as a borrower, but the upside is that you will keep the borrowed DAI.
There are clear signs that DeFi will continue to grow and bring more services available in the traditional financial industry to the blockchain. The goal is to give everyone with an internet connection access to financial services, which have long been available only to a few people. However, anything involving crypto is highly risky, so research before you take out a crypto loan.