How does DeFi Lending Work?
By now, you know that DeFi lending aims to offer a transparent, permissionless, and open-source financial service environment.
Now let’s move on to discuss the commonly asked question, “how does DeFi lending work”.
DeFi lending, or decentralized finance lending, is quite similar to the traditional lending service offered by the banks, except that it is offered by the P2P decentralized applications (DApps). The DeFi lending platforms help people borrow and lend funds which allow the crypto holders to earn a substantial income.
The DeFi lending process is simple. It focuses on offering crypto loans with a trustless approach. This means that the users can easily lock their crypto assets on the DeFi lending platform without worrying about intermediaries. The borrowers can directly opt for loans from the decentralized platform with the help of P2P lending.
In addition to it, the DeFi lending protocol helps lenders to earn interest on crypto assets. As compared to the conventional loan processing system of the banks, DeFi lending enables individuals to become a lender just like a bank. An individual can easily lend their assets to others and accrue interest on that loan. Just like the loan offices in traditional banks, DeFi lending mainly relies on the lending pools where the users can add their assets to the lending pool and ensure quick distribution among borrowers through smart contracts.
With various mechanisms for the allocation of interest to investors, it is crucial for lenders to identify the type of interest. Borrowers also need to do their part of research on the lending pools as each pool has a different borrowing approach.
How is DeFi Lending Different from Traditional Lending?
The traditional financial system provides borrowing, lending, margin trading, and spot trading. The DeFi ecosystem, however, has adapted and can offer similar financial services.
One of the crucial differences between DeFi and traditional lending is that conventional banking involves a time-consuming process along with continuous checks on a customer’s status. DeFi, on the other hand, grants loans quicker as long as the individual meets all the collateral requirements.
The smart contracts take care of the entire reviewing process, making it easier for the borrower and the lender. DeFi lending typically offers better returns when compared to the traditional lending markets.
What Kind of Benefits does DeFi Lending Provide to its Users?
DeFi lending mainly works by engaging the participants to contribute funds by depositing them at interest. These interest rates are more lucrative than the rates offered by traditional banks. Other than that, there are multiple benefits of DeFi lending as compared to the traditional lending system. These include:
Accountability is one of the top benefits of DeFi lending. Blockchain is a public ledger that can offer on-demand records of all the DeFi loans along with the policies and rules that granted that loan. The public distributed ledger mainly serves as proof of all the financial transactions when a particular DeFi loan gets granted.
Having a complete digital process for lending mainly helps in the assessment and monitoring of the borrowing and lending market. Lending analytics is another major benefit of the DeFi lending process. The lending analytics can be utilized for optimizing funds. It also allows various DeFi lending platforms to gain insights on loan sources that can help them improve the performance of the loan.
DeFi loans are processed quickly, and the lent amount is available instantly once the loan is approved. DeFi loans are processed faster because the DeFi lending platforms are powered by cloud services that help identify any fraud and other DeFi lending risks.
Immutability and Transparency
Blockchain can be easily verified by any user present in the network. DeFi lending ensures transparency as the decentralized nature of the blockchain mainly ensures that all the transactions are genuine.
Decentralized lending offers permissionless and open access to anyone with a DeFi crypto loan wallet. One can easily access the DeFi applications built on blockchain networks regardless of the presence of their fund or geographical location.
Interoperability and Programmability
By utilizing the interconnected software stack, one can ensure that the DeFi lending protocols complement and integrate with each other. Also, smart contracts are highly programmable and enable the development of financial instruments and digital assets.
Crypto wallets and DeFi lending protocols like Metamask, Gnosis Safe, and Argent enable the users to be the sole custodians of their crypto assets. It also allows the users to interact with the decentralized applications securely and avail the services of selling, buying, earning interest on investments, and transferring crypto.
DeFi lending platform has now come up with innovative ways of savings management. By plugging into different lending platforms, users can maximize their earnings and avail the services of interest-bearing accounts.
Constraints in Decentralized Lending
Several prominent discussions about decentralized finance largely focus on the benefits of DeFi lending. However, it is equally vital to highlight the cons for analyzing its potential effectively. Here is the list of critical setbacks that you can encounter soon after adopting DeFi lending:
If there is any instability while hosting a blockchain in a DeFi lending, then the process can automatically inherit instability directly from the host blockchain. Currently, the Ethereum blockchain is undergoing various changes. For example, the mistakes committed during the PoW consensus transition to the new Ethereum 2.0 POS system could lead to risk.
DeFi lending can encounter difficulties maintaining scalability for the host blockchain from various aspects. For example, the DeFi transactions require more time for confirmation. At the same time, the DeFi protocol transactions could become a bit expensive during the congestion period. Overall this affects the entire scalability.
Amongst all the disadvantages, the shared responsibility factor completely works the opposite for the users. If there is an error from your end, the DeFi projects do not take responsibility. All they do is take away the intermediaries, so only the user becomes responsible for their assets and funds. Therefore, the DeFi lending process requires tools that can prevent the possibility of human errors or mistakes.
Liquidity is another crucial factor in blockchain protocols and DeFi-based lendings. As of June 2022, the total value locked in the DeFi project was around 77.29 billion US dollars. For a better understanding the current TVL of DeFi market, refer to the infographic below:
The market value of DeFi has declined to less than 80 billion US dollars since June 2022. These significant changes caused the DeFi market to get highly impacted by the crash for Terra (LUNA) and its stablecoin Terra USD (UST) on May 22, when coins such as USDD lost their peg to the US dollar.
Other than that, a declining crypto market has also impacted the DeFi lending process. Therefore, it is evident that the DeFi market is not as trustable or big as the traditional financial systems. So, it can be difficult to put your trust in a sector with liquidity concerns.
Top DeFi Lending Platforms
DeFi lending platforms offer loans to businesses or the public with no intermediaries. DeFi lending protocols enable people to earn interest on cryptocurrency and supply stablecoins. Here is the list of top DeFi lending platforms:
Compound is a kind of autonomous interest DeFi lending rates protocol utilized for open financial applications. Users can directly earn a passive income by depositing the cryptocurrency through borrowing and interest crypto.
Compound grants the holders the right to vote on certain decisions like technically upgrading the platform and adding new assets. As a crypto lender, you will get a CToken as per the amount they supplied to the liquidity pool. A CToken is specific to those digital assets provided in the liquidity pool. These tokens will earn interest based on the liquidity pool’s respective interest rate. The top 3 markets on Compound are USDC, ETH, and DAI.
Aave is yet another popular DeFi lending platform that was launched in 2020. It is non-custodial and an open source liquidity protocol. Aave allows its users to deposit crypto in the liquidity pool soon after which they will receive the same amount of ATokens.
The interest rates are adjusted as per the current demand and supply in a given liquidity pool with an embedded algorithm. The interest defi lending rates increase with more AToken holders. Read this blog to know more about asset tokenization in blockchain.
YouHodler is another hybrid platform that provides crypto-backed lending with stablecoins and fiat loans. The mission of YouHodler is to help people to stop passive holding (buy-and-hold strategy) and utilize crypto assets completely. Based out of Switzerland, YouHodler, also offers an exchange policy.
The exchange supports fiat, crypto, and stablecoins. YouHodler offers better interest rates when compared to the other lending platforms. The current interest rate is 12.3% which is better than other lending platforms like crypto.com, Binance, Celsius Network, and BlockFi.
Built on the Ethereum network, Uniswap is a decentralized crypto exchange. One of the biggest advantages of this platform is that the users can get complete control of their funds with the exchange of smart contracts.
Also, new coins can be easily listed on the exchange with the help of a factory smart contract. Users can easily swap their ERC-20 tokens leveraging Uniswap.
MakerDAO is a decentralized lending platform from which you can only borrow DAI tokens. DAI is a kind of stablecoin that is pegged to the US dollar. You can easily borrow DAI through Maker while offering collaterals like BAT or ETH.
The users of MakerDAO are encouraged to take part in the operational earnings, which are only the interest rates for the network. Users can borrow DAI up to 66% of the collateral value.
What is a token swap?
As the name implies, a token swap is a process during which investors swap their existing tokens for another kind. Own Ethereum? You can simply swap ETH tokens for AAVE and have the exchange executed within minutes.
But what is so special about token swaps, and how do they differ from standard trading? Token swapping is exclusively performed on a DeFi protocol, particularly a decentralized exchange. These exchanges are non-custodial (meaning that they do not require ownership of your assets to move funds) and rely on liquidity delivered by users through the means of yield farming or liquidity mining.
Since decentralization is involved, swapping tokens is entirely regulated by smart contracts. There is no need for input from the exchange, nor are there any human factors involved that can lead to errors (except for those already embedded into code).
But this is merely the first definition of token swaps. In a different context, a token swap is referred to as the process of moving tokens from one network to another. This is commonly done when developers move their project from the original blockchain to a newer one, usually for the purpose of improving the platform’s capabilities.
Are DEX Token Swaps Better Than CEX Trading?
Why are token swaps so highly coveted? Are DEX token swaps better than CEX trading? Let us reach a conclusion by covering a practical example.
A Uniswap user wishes to exchange funds. He does so by logging into his digital MetaMask account and connecting with the DEX to request a token swap. After processing the request, Uniswap’s smart contracts pull tokens from the MetaMask wallet in exchange for the trader’s desired token.
The person in question did not have to:
- Log in
- Move funds to the exchange
- Convert fiat into crypto beforehand
Moreover, since DEXs by design enforce no Know Your Customer (KYC) parameters, your identity is almost completely anonymous. There are also no limits as to how much fiat value one can swap during a single day, which is a stark contrast compared to centralized exchange (CEX) withdrawal and deposit limits.
There are, of course, disadvantages as well. The cons include:
- Liability. In a decentralized environment, all actions and their consequences are delegated to the user. If a trader executes a trade by mistake or transfers assets to the wrong address, it is entirely their fault. There is no form of technical support that can escalate and resolve the issue, which is almost always found on CEXs.
- Security. Non-custodial wallets are primarily used when executing token swaps. They are fully managed by the owner, and all problems arising during trading have been explicitly caused by him. If the investor does not protect his wallet well, he risks losing all funds.
- Fees. DEXs rely on the use of Automated Market Makers (AMMs) to pull and push liquidity. AMMs are essentially smart contracts, and every action performed requires a respective smart contract that consumes gas fees provided by the user. Gas fees are exceptionally expensive compared to the standard taker/maker fees imposed by traditional order-book-styled CEXs.
How to Swap Tokens
No matter how alien the concept sounds, swapping tokens is rather simple. Initially, users must familiarize themselves with the interface, but after completing a swap, trading on DEXs comes naturally.
In this guide to token swaps, we will use the Uniswap DEX and MetaMask web wallet as examples. Asset-wise, the guide covers converting ETH into USDT. Keep in mind that the process is executed the same way, no matter which tokens you choose.
If you want to swap as you read this guide, make sure that you have the following prerequisites:
- A MetaMask wallet (alternatively a different web wallet)
- ETH tokens (alternatively any other ERC-20 token)
Are you ready? Let us start with the first step.
1. Visit Uniswap
The official Uniswap website can be found at Uniswap.org, while the DEX itself is located at app.uniswap.org. Searching for Uniswap on Google will yield the same results but always make sure to check the links in order to confirm the website’s identity. Visiting a copycat website imitating Uniswap is not advisable as it can lead to losses.
2. Connect your MetaMask Wallet
After entering the aforementioned website link, locate the ‘Connect to a wallet’ button found in the top right corner and select MetaMask. Doing so will open a window on the app which asks that you confirm the connection between Uniswap and MetaMask.
3. Select Tokens to Swap
At the main window at the very center, you are free to choose from a list of tokens. The first option depicts the token you own, while the second option represents the token you wish to receive. In this case, we will select ETH in the top field and USDT in the bottom field.
4. Execute the Order
You are almost there. Input the sum that you wish to swap and check the estimated amount expected to be received. If you are happy with the results, continue by clicking the ‘Swap’ button.
Once again, a MetaMask pop-up window will appear. Here you can adjust gas fees and gas priorities, but in general, you can advance further without editing these parameters. If the fees suit you, click confirm to go through with the token swap.
That’s it! The transaction will be confirmed within the span of minutes, depending on how much gas you have spent. If the transaction is a success, you will find USDT in your wallet.