Cryptocurrencies are very important tools in decentralized finance for borrowing and lending. In 2009, when Bitcoin was launched, it was to serve as a decentralized form of money that would aid peer-to-peer transactions. Following the release of Bitcoin, thousands of other cryptocurrencies have been created, and most of these have a role to play in DeFi.
In the world of DeFi, regular financial procedures like borrowing and lending are replicated but on a decentralized network. Users can borrow, lend, and earn interests from locked funds or capital. This article sheds light on how borrowing and lending work in a decentralized ecosystem and differs from traditional finance.
How does Crypto Borrowing and Lending Work?
Crypto borrowing and lending employs cryptocurrencies rather than fiat as financial tools. The most popular cryptocurrencies for borrowing and lending crypto are Bitcoin, Ether, and stablecoins like DAI, USDC, and USDT.
The two main participants are the borrowers and the lenders. Notably, a decentralized protocol run by a smart contract is usually needed to make it work. Although centralized crypto platforms have adopted the concept of borrowing and lending cryptocurrencies, it all started with decentralized protocols.
The borrower requests funds, while the lender makes the fund available and specifies the loan duration. Just like regular loans, if the borrower defaults or fails to pay on the set date, there will be penalties. The penalty could be liquidation of collateral, or a fine or extra fee paid for the delay.
Crypto loans are also valued at a lesser amount than the collateral. The loan value usually falls between 60-75%. However, this largely depends on the loan protocol and the nature of the assets used. Crypto borrowing and lending could be via a DeFi protocol or a centralized exchange.
Borrowing in DeFi Protocols
On DeFi protocols, users can borrow and lend without an intermediary. Unlike regular financial systems involving intermediaries, participants interact directly with smart contracts.
Smart contracts enable the financial procedure to pull through automatically. The lenders deposit their funds in a liquidity pool, and when the lender’s conditions are met, the funds are released to the borrower. Further, when the borrower repays a loan, the collateral is returned to the borrower.
The concept of borrowing and lending in crypto was made famous by Maker DAO and Aave protocols. In these DeFi protocols, loans are over-collateralized. This implies that borrowers can collect a loan of lesser value than the collateral provided. DeFi protocols support loans and collaterals in cryptocurrency only.
So why do users borrow cryptocurrencies using another crypto as collateral? While this sounds irrational at surface level, there are good reasons to do this.
Let’s assume a trader owns 1 BTC at a current price of $24,000. However, the trader suddenly needs money urgently to cover some expenses but has no cash, just Bitcoin. The trader may be tempted to sell all or part of his BTC to get the money needed.
But what if the trader expects a massive bull run for Bitcoin in the coming weeks or months due to some economic situations. If the trader does not want to miss out on the projected price appreciation, a loan would be the best option.
Obtaining a loan from a DeFi protocol using his BTC as collateral and using the loan to carter for the urgent needs would prevent the trader from missing the profits if BTC’s price eventually appreciates. In the scenario painted above, the crypto loan would help the trader make profit should Bitcoin’s price increase. However, the trader could also lose if BTC’s price declines during the period of expected increase. This implies that crypto borrowing could also be risky.
Interestingly, there are other reasons to obtain crypto loans aside from projected price increase. For experienced traders, flash loans could be used to make profits. Also, folding strategies can be implemented with crypto loans.
Flash loans are loans obtained and returned in a flash. You do not need collateral to obtain flash loans. Also, they must be retuned before a block is completely mined on a blockchain protocol. Thus, flash loans can’t be collected without being repaid, even though they do not require collateral.
Traders collect flash loans to exploit arbitrage opportunities or price variations on DeFi protocols. Since price may have slight variations at different times across exchanges, traders can use this opportunity to buy a crypto asset at a lower price and sell at a higher price. Flash loans could be obtained as much as a million dollars’ worth or even more. Even when the price variations across DEXs differ by as low as 0.1%, traders can make significant profits. For example, 0.1% of $1,000,000 loan is $1,000.
With folding strategies, traders can repeat the process of borrowing multiple times. For example, let’s assume a trader owns 10 BTC. The worth of his 10 BTC can increase over time by implementing folding strategies. If the trader uses the 10 BTC to borrow 7 BTC at a total loan value (TVL) of 70%, the trader now has crypto in his custody, equivalent to 7 BTC.
The trader can use the 7 BTC worth of crypto to borrow another cryptocurrency valued at 4.9 BTC (70% of 7 BTC). Further, the 4.9 worth of crypto can be used to borrow another 3.43 BTC or its equivalent in another cryptocurrency. The process continues, and the trader eventually uses 10 BTC to own multiple fractions of BTC for a certain period. The cumulative fractions eventually surpass the worth of the 10 BTC he initially had. Note that the trader only becomes “richer” during the contract period.
Borrowing on CeFi Platforms
Today, centralized exchanges have adopted the borrowing models in DeFi lending protocols. Exchanges like Binance and Gate.io offer crypto lending to users. They are based on the same principles in DeFi lending protocols, only that the exchanges serve as intermediaries in this instance.
While flash loans cannot be executed on CeFi protocols, folding strategies can be implemented. One advantage of CeFi protocols is their capacity to provide deep liquidity. Hence, CeFi protocols contribute to making the crypto borrowing and lending seamless. Although, web3 fans are strongly against letting intermediaries hold crypto assets for users.
Borrowing and lending is a very vital part of finance. Borrowing and lending in decentralized finance works slightly differently from traditional finance. In traditional finance, tangible collaterals are used to obtain loans. However, in DeFi protocols, cryptocurrencies are used to borrow cryptocurrencies. Further, DeFi loans have added benefits like flash loans and multiple layers borrowing that are absent in traditional finance. Although DeFi borrowing and lending can be risky, its benefits surpass the downsides.