22 Nov, 2022
5 min read
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.
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.
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.
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.
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.
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 (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.
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:
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:
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.