Decentralized finance (DeFi) continues to increase access to online financial services with an innovative array of intermediary-free projects. Although peer-to-peer (P2P) trading remains one of the hottest activities in DeFi, crypto borrowing and lending sites have become a major force in the decentralized digital economy.
And as more people become comfortable with the security of smart contracts—and as blockchains become more scalable and interconnected—this piece of the DeFi ecosystem is well-positioned for future growth.
But how do DeFi lending platforms work, and are they safe for crypto traders to try? Let’s explore the ins and outs of DeFi lending, including its benefits and drawbacks.
What is DeFi lending? An intro to DeFi loans
DeFi lending is a financial service available on decentralized applications (dApps) where traders directly borrow and lend digital assets in their crypto wallets. Just like taking out a loan from a centralized financial institution, the borrower on a crypto lending dApp has to put down collateral and make regular payments (plus interest) to the lender until they repay their loan.
The difference between DeFi and centralized finance (CeFi) lending is that the former doesn't have a third-party intermediary monitoring loan activity or screening clients for traits like creditworthiness. DeFi loan platforms like Compound, Aave, and MakerDAO run on top of decentralized blockchains like Ethereum (ETH), providing borrowers and lenders with a P2P lending experience. Each loan's transaction information is publicly viewable on a blockchain's distributed payment ledger, and transfers happen using self-custodial crypto wallets like MetaMask rather than creating accounts with personal know-your-customer (KYC) information.
How does DeFi lending work?
DeFi lending protocols use smart contracts to automatically approve, distribute, and terminate cryptocurrency loans in their ecosystems. These smart contracts operate on blockchains like Ethereum or Cosmos (ATOM) and use "if/then" commands to identify state changes on the network and initiate actions when certain conditions fall into place.
In the case of crypto lending platforms, developers design smart contracts to not only recognize collateral deposits and payments from borrowers but also distribute crypto interest to the lender during the loan term. When a smart contract registers the borrower paid off the loan, it unlocks the crypto collateral and sends it to the loanee’s crypto wallet.
To ensure the collateral’s value equals the amount a borrower requests from a DeFi loan protocol, many dApps only issue overcollateralized loans. For context, overcollateralization means borrowers must deposit more crypto than they intend to take from the protocol.
For example, if a DeFi dApp has a 200% collateral requirement for an Ethereum loan, a user needs to deposit 2 ETH to borrow 1 ETH. Overcollateralization aims to manage the price volatility associated with crypto assets and avoid the risk of borrowers defaulting on their loans. If the value of deposited collateral ever dips below a dApp's pre-established percentage for borrowed funds, borrowers must pay off their loan or deposit more collateral to avoid liquidation.
What are DeFi flash loans?
While many DeFi lending protocols use overcollateralization, one subcategory called DeFi flash loans doesn't require borrowers to deposit any collateral. The catch here is that traders must repay their loan before the next transaction block posts on a blockchain (which typically only takes a few seconds or minutes). If the borrower fails to repay the loan by the next block, the smart contract instantly reverses the transaction.
Due to their extreme demands, DeFi flash loans are typically used by professional day traders with sophisticated high-frequency trading algorithms primed to pounce on opportunities like microtrends or minor price discrepancies between crypto exchanges (aka arbitrage).
What are the benefits of DeFi lending?
Lending crypto for interest payments is one of the liberating opportunities DeFi technology makes possible. Thanks to blockchain and smart contracts, individuals with cryptocurrency can originate loans and access a global audience to create passive income streams. Besides opening up new cash flow possibilities, DeFi loans promise to remove some security, governance, and transparency hurdles associated with CeFi lending services.
- Provides passive income opportunities: DeFi lending allows everyone to earn interest on digital assets by contributing to crypto loan pools. As long as crypto traders have cryptocurrency in a compatible wallet, they can participate in crypto lending protocols and generate passive income from their holdings.
- Removes points of centralization: Blockchain technology’s decentralized structure eliminates risks such as a single vulnerable server and overreliance on trusted counterparties. Since DeFi lenders interact with smart contract codes rather than centralized entities, traders don’t have to rely on an intermediary's security and storage standards.
- Promotes transparency: Because DeFi protocols are on blockchains, lenders can access verifiable online records of all their transactions via the distributed payment ledger. Tracking the accrued interest over time and payment rates for outstanding loans on blockchain systems is also straightforward.
- Offers governance rights and token rewards: Many DeFi lending protocols empower community members with voting rights on decentralized autonomous organizations (DAOs) with governance tokens. These governance-focused cryptocurrencies let traders vote on dApp upgrades and submit improvement proposals, helping create a sense of community and democratizing dApp decision-making.
What are the risks of DeFi lending?
DeFi lending offers crypto traders a flexible way to earn interest, but all this comes with a few risk factors. Before diving into DeFi loans, consider the following vulnerabilities and drawbacks:
- Smart contract exploits: Because smart contracts play a major role in automating transactions on DeFi lending protocols, traders need to feel comfortable with the security of these programs. If smart contracts have bugs or weak spots, malicious actors can take advantage and potentially drain users' accounts.
- Impermanent loss: In an impermanent loss scenario, lenders earn less (or lose more) on a DeFi loan dApp than if they had kept their crypto in a private wallet. Although this phenomenon is often associated with liquidity pools on decentralized exchanges (DEXs), it impacts DeFi lending protocols as the market prices and the composition of a dApp’s digital assets change.
- Price feed manipulation: Besides smart contracts, DeFi platforms often use oracles like Chainlink (LINK) to provide accurate, real-time price feeds on cryptocurrencies from off-chain sources (e.g., centralized crypto exchanges and crypto price aggregators sites). If bad actors compromise the data from oracles, it obscures the true market value of digital assets on crypto loan sites, potentially leading to inaccurate collateral values and losses for lenders and borrowers.
- No insurance protections: DeFi doesn't offer traders insurance protections on any digital assets they choose to deposit in loan pools. While dApps use smart contracts and overcollateralization to avoid liquidations, there's no way to guarantee crypto loan reliability, and traders have no recourse to recover funds during a security issue.
How to lend crypto on DeFi lending protocols
Crypto traders don't need special credentials or credit scores to get started earning interest from a crypto lending dApp. As long as traders are comfortable with the risks associated with this passive income strategy, it only takes the following four steps to get started:
1. Research DeFi lending opportunities
Start by finding a safe dApp with a solid reputation and high liquidity. An excellent way is to use a third-party DeFi tracking site like DeFiLlama and scan data like the total value locked (TVL), news, and treasury composition for different protocols. While names like Aave, Compound, and MakerDAO are some of the oldest, largest, and most reputable crypto lending dApps, explore all the available options and research their features before committing. Also, be wary of DeFi lending protocols with limited transparency or questionably high interest rewards for lenders, as these may be warning signs of a crypto scam.
2. Install a compatible crypto wallet
After selecting a DeFi lending dApp, figure out which crypto wallets work on this protocol and install one onto a desktop browser or mobile phone. MetaMask is a popular choice for Ethereum or Ethereum Virtual Machine (EVM)-compatible dApps, but many other options exist within and outside the Ethereum ecosystem. Spend time researching the features and reputation of each crypto wallet before deciding which to use for crypto loans.
3. Buy or transfer cryptocurrency
Some wallets like MoonPay offer fiat-to-crypto services to help traders buy virtual coins like ETH, but often, traders pay extra fees for this convenience.
If you have an account on a spot crypto exchange or digital assets tucked away in another wallet, transfer cryptocurrency to your public wallet address in DeFi lending. Remember, blockchains charge gas fees for every transaction, so factor in these costs when deciding how much to send. Also, only use the public key in the recipient wallet for the intended cryptocurrency, as sending crypto to a non-native blockchain results in lost funds (e.g., only send Ethereum to an Ethereum wallet address, Cosmos to a Cosmos address, and so on).
4. Link a crypto wallet on a DeFi lending protocol and pick a loan
Many DeFi lending dApps have a Link Wallet tab on their homepage where users choose a crypto wallet (e.g., MetaMask, Phantom, or Rainbow Wallet) and connect their accounts. After successfully linking a crypto wallet, explore the accepted cryptocurrencies for lending pools, term conditions, and the estimated DeFi rates of returns. Many DeFi protocols use annual percentage rate (APR) and annual percentage yield (APY) to quote expected returns, with the latter factoring in compounding interest. If there's an attractive DeFi loan pool, consider depositing crypto funds from the linked wallet account and regularly monitor rewards on the dApp.
Dive deep into DeFi with dYdX Academy
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