What is DeFi? A detailed explanation of DeFi lending

There are many different applications in the DeFi field, and they provide coinage, consumption and transfer methods that can replace traditional finance.

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The operating model of DeFi lending

The largest lending platforms currently operating in the DeFi space are Compound, Maker, Aave, CREAM Finance, and dYdX, generating a combined $106 million in interest annually. While they all operate a little differently, overall the basic principles are the same.

At the heart of decentralized lending are the smart contracts that make it work. The mechanism is code that executes automatically once certain conditions are met, and eliminates the need for a centralized authority to operate and manage interactions between parties. By writing the loan rules into smart contracts, users can pool assets through smart contracts and then distribute these assets to borrowers.

Like traditional loans, borrowers need to put in collateral to take out a loan. In DeFi, borrowers deposit cryptocurrencies into smart contracts as collateral whose value is at least equal to or even greater than the value of their loan. Which currencies are used as collateral mainly depends on the lending pool you access and which currencies are supported by the lending platform.

After the loan is over, as a borrower, you need to repay the currency you borrowed and the agreed interest. Then, the extra funds you deposit will be distributed to the lenders in the pool as interest. This is why people are so interested in lending money – the funds they hold are not just idle assets, but are put to work and generate money from money in the form of interest payments.

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The Risks of DeFi Lending

Cryptocurrencies are known to have the potential for wild price swings on any given day. What happens when the price of the deposited collateral falls below the loan price? Your loan will be penalized by liquidation. For this reason, most platforms require overcollateralization, meaning users must deposit a higher amount than they intend to borrow.

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All innovations in the crypto space are exciting and look promising. But as with everything that operates on the innovation front, you need to do your homework to make sure you understand all possible risks and figure out which project is best for you.

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stable currency

Many lending pools will list stablecoins as assets, such as DAI, USDC, and USDT. Stablecoins are an important part of the DeFi universe, so you need to understand how stablecoins operate and what is the difference between the various stablecoins traded in the market.

WBTC

Wrapped BTC is an ERC20 token against BTC. It is widely used in DeFi protocols and has been the main driver of liquidity in DeFi. Although WBTC stands for Bitcoin, you need to understand that WBTC does not mean actually holding Bitcoin.

Compound

Compound works a little differently: your locked assets will be tokenized via cTokens. This model enables your locked assets to be traded and used in other decentralized applications (dApps) throughout the DeFi ecosystem.

Aave

As a DeFi lending protocol, Aave is similar to Compound, but with some unique features that push the boundaries of financial innovation. Flash loans, flexible rates, and credit authorization are all new services and hallmarks of Aave as a leader driving greater expansion of DeFi.

DeFi

If you want to learn more about the strengths and weaknesses of decentralized finance, as well as its future prospects, read our latest research article.