Decentralized Lending Markets: A Deep Dive

paul faecks
Summary: 
  • Lending markets are one of the largest subsectors of DeFi with over 10b$ locked
  • Decentralized lending markets work with transparent rules
  • We view DeFi lending as sitting at the top of the capital stack as the most senior tranche of debt, as it economically incentivizes paying back debt before other, more junior tranches of debt 

Traditional vs. Decentralized Lending

Lending and borrowing are crucial mechanisms of modern banking, driving economic development worldwide. Every day, lenders provide borrowers with liquidity under an agreement that stipulates these funds will be paid back over time, with interest. Traditionally, these interactions are facilitated by banks or other financial service providers that serve as intermediaries. Specifically, these entities bring borrowers and lenders together, powering the fractional reserve banking system. This legacy banking model uses a percentage of bank deposits as credit for borrowing customers.

In contrast, decentralized lending utilizes blockchain-based cryptocurrencies to facilitate borrowing and lending activity. These decentralized protocols employ smart contracts to execute transactions, meaning there are no human intermediaries. As a result, users retain custody of their funds, eliminating the need for a central authority. Let’s take a closer look at how these mechanisms work.

How Does Decentralized Lending Work?

Decentralized lending has become a significant component of the decentralized finance (DeFi) ecosystem, with nearly $9 billion locked in the top three protocols alone at the time of writing. Using these platforms, borrowers can deposit their crypto as collateral in exchange for loans. Conversely, lenders can deposit or stake digital assets using liquidity pools to generate yield. So, why have these platforms become so popular? In short, they allow investors to maintain ownership of their digital assets while unlocking liquidity.

For example, if someone has $10,000 of ETH, but they don’t want to sell it, they can supply it to a lending protocol and borrow up to 75% of that value, depending on the collateral ratio of the platform in use. Although most loans require over-collateralized, it’s still beneficial for investors to gain access to a large portion of their otherwise illiquid crypto wealth.

After receiving a loan in the form of crypto or fiat currency, traders can use these funds to execute margin trading on the open market, acquire tokens they don’t own for liquidity mining, or pay for real-world emergencies. Decentralized lending can be lucrative for hedge funds and prominent investors with significant digital asset holdings. These entities can borrow against their digital assets, receiving loans to move into traditional financial instruments. It’s important to note that these are only a few examples of what can be done with decentralized lending protocols—highly complex strategies can also integrate yield farming opportunities.

The Decentralized Lending Ecosystem

According to DeFiLlama, there are around 179 active decentralized lending protocols. However, at the time of writing, the vast majority of value was locked in Aave, Compound, and JustLend. Below, we’ve broken down how these, and other popular decentralized lending protocols, work.

Aave

As the most popular DeFi lending platform, Aave facilitates lending and borrowing without a centralized intermediary. Users can deposit digital assets into liquidity pools which become funds that the protocol can lend out. Notably, in July 2022, Aave’s community approved the launch of GHO, a decentralized, collateralized stablecoin.

Compound

As one of the top decentralized lending protocols, Compound operates as an algorithmic and autonomous money market protocol designed to support multiple financial applications. Specifically, traders can utilize Compound to generate interest on cryptocurrency deposits or borrow against them. Because the Compound protocol is non-custodial, anyone with a cryptocurrency wallet and an internet connection can interact with the platform. At the time of writing, Compound supported numerous assets, including DAI, ETH, WBTC, REP, BAT, USDC, and ZRX.

JustLend

The JustLend protocol is a coin market built on the TRON blockchain. Liquidity pool interest rates on the platform are determined by an algorithm based on the supply and demand of TRON digital assets.

Maker (Oasis Borrow)

Maker (branded Oasis borrow for their lending offering) allows users to borrow their stablecoin Dai against ETH, wBTC, stETH, and even certain Curve & Uniswap LP positions. 

The Benefits of Decentralized Lending

Because decentralized lending platforms are built on blockchain technology, there are several benefits to using them over traditional lending platforms—here are a few of them:

  • Senior Debt at the Top of the Stack, by Design 
  • Overcollateralized DeFi lending incentivizes borrowers to pay back loans by always having more $ notional collateral locked than $ notional in loans against that collateral. Both Celsius and Alameda paid back their debts on lending platforms such as AAVE, while unsecured creditors can only hope to get cents on the dollar back after years of bankruptcy proceedings. It goes against economic incentives not to. Smart contracts are displacing senior debt at the top of the capital stack.

  • Accessibility: 
  • Traditional lenders can set their own terms and conditions when vetting customers. In contrast, decentralized lending platforms improve financial inclusion, allowing anyone with adequate collateral to participate.

  • Lower Fees: 
  • Loans generated on DeFi lending platforms usually come with lower fees than traditional lenders. The absence of intermediaries and collateralized debt positions (CDPs) lowers costs, which savings passed on to protocol users.

  • Transparency: 
  • Because decentralized lending protocols live on-chain, with all activity recorded to the underlying blockchain, they are inherently more transparent than traditional lending platforms. This transparency allows borrowers and lenders to shop for the best rates and establishes trust between all parties.

The Risks of Decentralized Lending

Like any financial service, there are also risks associated with using decentralized lending platforms. And while these protocols have remained remarkably stable throughout recent market volatility, it’s important for investors to exercise due diligence:

  • Market Volatility: One of the biggest risks to decentralized borrowers is crypto market volatility. If the price of their crypto collateral drops significantly, the platform will liquidate the position (sell the digital assets) to cover the loan and prevent a protocol loss. Conversely, when crypto prices fall, the value of a lender's loan also drops, meaning they will likely earn less interest.

  • Protocol Performance: Although the most popular lending protocols have proven resilient, there’s always a risk of bugs, vulnerabilities, and hacks. Smart contracts may automate activity and eliminate intermediaries, but they shouldn’t be considered perfect.
  • Economic Attacks/ Oracle Manipulation: A risk with decentralized lending are economic attacks targeting oracles (price feeds) protocols use for liquidating positions. While large protocols such as AAVE have proven themselves to be resilient by being careful in their selection of tokens that can be used as collateral (AAVE did not allow FTT, FTX’s token to be used as collateral for example), there are risks associated with attackers supplying less liquid tokens as collateral, artificially inflating price and then max borrowing against the inflated collateral value, leaving the protocol with bad debt. 

The Role of Decentralized Lending Markets

Despite the risks, decentralized lending generates several benefits for borrowers and lenders compared to traditional alternatives. Simply put, these autonomous protocols give borrowers access to low-cost capital and a higher degree of transparency while providing lenders with improved liquidity and flexibility.

As the growth of DeFi accelerates and more institutional investors enter the market, it seems likely that decentralized lending will play an increasingly important role in the ecosystem. As these protocols prove their resilience, it’s reasonable to suggest they will serve as a critical bridge between traditional and digital finance.

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