Why are DeFi lending protocols like Aave, MakerDAO and Compound Finance so popular? Well, crypto sitting in your wallet may fluctuate with price movements, but what about earning some passive income? DeFi loans are one way traders grow their crypto with assets they already hold.
What is lending in crypto?
Know about bank loans? DeFi loans follow the same logic, with a different execution.
Crypto lenders provide funds to borrowers, who are expected to pay them back with interest at the end of the loan period. However, while traditional loans require a third-party intermediary (banks/moneylenders), crypto loans facilitated via DeFi protocols use smart contracts (code) to create lending pools.
Unlike in bank loans where the borrower’s identity is doxxed and their tangible assets (i.e. house, physical possessions) can be seized if they cannot repay their loans, DeFi loans are decentralized and anonymous. Hence, borrowers would need to provide collateral in the form of other crypto before securing their loan.
Both lenders and borrowers send funds and collateral, respectively, to the lending pools. The smart contract is able to allocate funds to borrowers after receiving their collateral. It will also allocate interest to lenders as incentives.
How do DeFi loans work?
As mentioned, DeFi lending protocols use smart contracts. The loan process differs slightly from platform to platform; hence you should read up on the rules before securing a loan.
Most crypto loans have to be overcollateralized, meaning that you have to lock up more assets than the value of crypto you are receiving. This is to safeguard against price volatility - where the collateral’s value falls below the loan amount. Let’s use MakerDAO as an example.
Credit: Oasis, MakerDAO
Scenario: Amy wants to borrow $1000 DAI from MakerDAO’s ETH-C vault. She would have to collateralize her loan at a minimum of 170% of the value of the loan. This means that she would have to supply a minimum of $1700 ETH to borrow DAI. If Amy’s collateral falls below $1700 ETH, her vault may be liquidated and Amy will be considered “in debt”. MakerDAO will then take over her collateral to sell and charge a 13% liquidation penalty at the same time.
If Amy successfully repays the loan with interest, her ETH collateral will be returned. What’s more, if ETH’s price had increased during the loan period, Amy could have made an extra profit by the time of repayment.
Risks in DeFi loans
While DeFi lending and borrowing is relatively simple, take note of these risks:
- Smart contracts: Potential vulnerabilities within the smart contract is always a risk. The best way to circumvent this is to DYOR about the platform and check on their security audits before depositing your crypto. That said, there is never 0% risk in DeFi, or any form of investment for that matter.
- Price volatility: In more extreme market conditions, your collateral could drop in value and cause you to go into debt.
The views expressed in this article are the author's alone and do not necessarily represent the views of ApolloX.
Risk Reminder: Crypto and NFT trading carries a risk. All trading activities are done at your discretion and at your own risk. The information here should not be regarded as financial or investment advice from ApolloX. ApolloX will not be liable for any loss that might arise from your use of any financial product.
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