Explaining Lend & Borrow in DeFi and How it Differs from CeFi
Lend and borrow are two of the most active financial services currently active in today’s market. Be it traditional finance or in emerging fintech ventures, lending and borrowing verticals act as a major mainstream source of revenue taking up a huge market share. This is same for DeFi market as well. In normal markets, such services are provided by banks and major peer to peer financing firms whose sole product suite comprises of services such as loans, mortgages etc. These services also known as money markets are offered in two different verticals in crypto markets.
Difference between CeFi/DeFi
The first type is similar to banks and investment firms and is called centralised finance (CeFi) in which these two services are offered mirroring approach of more traditional and centralised market architecture. These CeFi firms take custody of depositor’s assets in exchange for lower but safe and stable returns to their clients. They then lend out the assets to other major players such as institutional market markets, hedge fund providers.
The second type — DeFi protocol-based lending and borrow service providers allow direct participation of end user. In here, a user can either directly borrow funds or lend it out while having direct custody of their funds as opposed to CeFi and traditional markets in which a user deposits the funds in a firm giving custody of how it is used to those firms. The direct peer to peer lending and borrowing is facilitated through smart contracts on an open source blockchain network.
Here the funds can be lent and borrowed at any given point of directly without revealing too much personal information aside from wallet information. Some of the well known DeFi money markets are — Aave, Market DAO, Compound, Solend, Oxygen and Port Finance.
How does lending work?
A lender in DeFi market deposits his token in a money market/liquidity pool using smart contract for which the user is rewarded in the platform’s native token. The mechanism behind how the interest is rewarded to user however is a point to be noted. The interest gains is calculated using ratio of supplied and borrowed tokens in the market. This results in varied interest rate as demand for tokens being borrowed dictates how much interest a user gains over period of time.
How does borrowing work?
To borrow in DeFi, a user needs collateral. While this may sound similar to traditional finance, the collateral a borrower submit in DeFi market needs to be of equal or more valuable than the amount of loan they borrow. While this may sound weird, this practise is put in place owing to highly speculative nature of how cryptocurrency market works. This practise of over collateralisation while seemingly absurd has its own advantages.
It helps guard against forced liquidation of crypto holdings which could appreciate in future, gain leveraging exposure on crypto asset for speculative trading purposes and avoid capital gain tax. The user is also limited in certain aspects when borrowing in DeFi as it depends on how much tokens are available in total fund pool in the market and collateral factor of network in which the DeFi platform is built on.
The Collateral factor is decided by DeFi operator which dictates maximum amount user can borrow depending on value of collateral deposited. There are also flash loans provided by certain DeFi lenders which don’t require any collateral. This type of loan is mainly used to support trading practises and a user usually pays back to borrowed amount before the transaction ends. It is a type of smart contract which prevents loss of funds by ensuring that funds don’t leave the account unless certain conditions are fulfilled and in case of failure the transaction is immediately reversed.
Are there any disadvantages?
While lending in DeFi is safer option despite lower (varied) interest rates, the borrowing comes with certain associated risks. One of the most common risk factor for any DeFi transaction is hacking and third party smart contract tampering. The risk associated with borrowing are possibility of collateral liquidation which happens when value of collateral crashes below liquidation threshold and prospect of borrow APY seeing an unexpected jump leading to user paying more amount than previously expected. Measures are being taken to guard against such events by major DeFi platforms such as guarantee for stable borrow APY’s and introduction of flash loan in market.