In both traditional finance and crypto finance, lending and withdrawing loans is the offering of fiat or digital currency to the other in exchange for a fixed income stream offered by one party.
The concepts of “lending and borrowing”, which have existed for many years, are among the foundations of the “fractional banking” structure, which is widely used worldwide today.
The idea is simple: Lenders provide funds to borrowers at a certain interest rate. In traditional structures, such agreements are facilitated by a financial institution such as a bank or an independent structure that lends itself to peer-to-peer (P2P).
When evaluated in terms of crypto currencies, apart from central structures such as BlockFi and Celsius, decentralized finance protocols such as Aave and Maker can be used.
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Centralized finance (Centralized Finance, CeFi) platforms work like a more traditional bank compared to decentralized alternatives. Taking responsibility for deposited assets, the protocol offers loans to third parties that make a request. This centralized system, which looks and works quite well on paper, can contain problems such as theft, hacking, and insider attacks.
Decentralized finance (DeFi) protocols, on the other hand, allow users to become lenders or borrowers in a completely decentralized manner. Thus, users have full control over their funds. This system is made possible by the use of smart contracts running on open blockchain networks such as Ethereum. Unlike CeFi, DeFi platforms can be used by anyone and anywhere, without having to transfer personal data to a central authority.
How does granting and receiving loans work on DeFi platforms?
The user sends the tokens he wants to lend against interest income to the “money market” through the smart contract and receives them from the platform’s local token at the rate of the amount sent.
Users who want to be “lenders” through DeFi protocols such as Aave and Maker send their tokens to the pool called the “money market”. This process takes place via the smart contract, which acts as an automated agent for the user’s assets. Then the deposited funds become accessible to other users who want to take out a loan.
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The smart contract automatically distributes interest tokens to the user who provides funds to the system. The minted tokens differ from platform to platform. For example, interest tokens are called aToken on the Aave platform, while in Maker they are called Dai.
Almost all loans made via local tokens are offered in “over-collateralized” form. In other words, users who want to borrow have to provide a guarantee that is more valuable than the loan they request.
On paper, this may seem a little ridiculous, as one has the opportunity to sell the assets deposited as collateral instead of borrowing. However, there are a few good reasons to borrow from DeFi:
- Users may need a loan to cover additional unexpected expenses, while not wanting to sell their assets, thinking they will be valued in the future.
- By borrowing money through DeFi protocols, they may be avoiding or deferring taxes on their savings.
- Investors can also use the funds borrowed through such platforms to increase their leverage on different trading positions.
How much credit can be withdrawn in the DeFi market?
The credit limit is determined by two main factors:
- Does the platform have sufficient liquidity?
- What is the “collateral factor” of the assets provided by the person?
First of all, how much credit a person can take depends on the size of the fund pool that can be borrowed from the market.
Then the “collateral factor” comes into play. This data expresses the total amount of funds that can be received according to the type of collateral offered to the pool. For example, DAI and Ether (ETH) assets on the DeFi loan platform Compound (COMP) have a 75 percent collateral factor. That is, users can borrow up to 75 percent of the DAI or ETH value they bring to the market.
In DeFi platforms, the credit withdrawal limit is determined according to the following formula:
In other words, those who want to borrow have the potential in proportion to the collateral factor of the asset they offer as collateral. Loan amount to be withdrawn; it cannot be greater than the product of the collateral asset and the collateral factor.
How is DeFi interest income distributed?
Users who want to lend through the DeFi platform select the relevant cryptocurrency and the smart contract alternative, then the interest amount is transferred directly to the user’s digital wallet.
The interest charged to lenders and borrowers is determined by the proportion of tokens available in the market. This rate is indicated by the abbreviation “APY”, which means annual revenue percentage.
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APY rates paid as interest are recalculated for each block generated in the blockchain network. Interest rates change from moment to moment depending on the request to borrow and borrow money on the DeFi protocol. Some protocols, such as Aave, provide their users with flash loan solutions in return for fixed “APY” and do not require upfront deposit.
Are DeFi loans safe?
Due to the nature of DeFi protocols, there are various risks such as the breakdown of smart contracts for various reasons and the astronomical increase in the rate of “ALM” applied to the borrower in a short time.
Compared to central finance options, DeFi loans pose no direct danger. However, as with any platform, there is always a risk in the DeFi area. There may be risks in smart contracts that are unpredictable and arise after a certain period of time.
In the “yield farming” platforms, which made a great success in 2020, the borrowing interest rates of some cryptocurrencies had increased to 40 percent and above. This has caused users who do not regularly check interest rates to pay more than they expected.
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In general, although the process of obtaining and granting loans through DeFi platforms is not complicated, each protocol has its own way of functioning. The wallets they support and the fees charged may differ.
Since there is no way to recover funds lost in error in such transactions, users should be extremely careful and make sure they use the correct wallet address information.
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