• /
  • DEFI

Lending and borrowing in DeFi

Lending and borrowing without relying on a bank

As we have mentioned in the first lesson, DeFi lending protocols differ from banks in that the whole protocol is entirely on-chain and not controlled by any centralized entity. This means that the difference between the lending and borrowing APY can be significantly smaller than in traditional finance, as the whole process runs much more efficiently.

We should note that there are also centralized lending and borrowing companies in crypto (such as Celsius and BlockFi, for example), which also offer better returns than traditional banking due to the increased efficiency of dealing with cryptocurrencies rather than fiat. However, this still requires you to trust the companies and to undergo KYC (Know Your Customer) checks, revealing your identity.

In DeFi, on the other hand, you only need to trust that the smart contract is well written and doesn’t contain any bugs (more on this in the next lesson), and you can borrow or lend crypto without revealing anything except your public wallet address.

Compound and Aave

To explain how lending and borrowing works, we can take the example of Compound and Aave, currently the two most popular protocols. Both work similarly when it comes to borrowing: a user deposits collateral into the protocol (in the form of a particular token) and receives a loan in another token. When the user pays back the loan plus interest, the collateral is returned to them.

Due to the volatility of crypto, DeFi loans are always overcollateralized. This means that, for example, if you want to borrow 1000 USDT with ETH as collateral, you need to deposit 1250 USD worth of ETH. So why would one take out a loan if they have to deposit more in collateral than the loan is worth (rather than just selling the collateral)?

The main reasons are that a user needs funds at a particular time in order to deal with some unforeseen event, or that they’re bullish on the collateral token and don’t want to sell it. In some jurisdictions, there are also tax benefits of taking out a loan compared to selling crypto.

When it comes to lending, the basic principle of Compound and Aave is the same, but it is implemented differently. In both cases, the user supplies an asset to the protocol, and that asset is then used for loans. In return for the tokens supplied, the protocol issues new tokens which represent the supplied asset plus interest (and which can be transferred just like any other token). When these tokens are returned, the user receives the underlying asset plus interest for the time that it was supplied.

The main difference between Compound and Aave is the ratio between the supplied tokens and the tokens that the user receives (these are called cTokens in Compound and aTokens in Aave). In Compound, the exchange rate gradually increases over time (e.g., the user receives 500 cETH tokens for 1 ETH, and upon redeeming them a year later, they receive 1.1 ETH for their 500 cETH tokens due to the change in exchange rate). In Aave, aTokens are issued and redeemed at a 1:1 ratio to the supplied tokens, and the protocol rewards interest by continually increasing the user’s aToken balance.

Interest rates and concluding remarks

Another important difference between DeFi and CeFi lending and borrowing is that the interest rates are usually calculated for each block, according to the supply and demand for each particular asset. For example: if the money market for ETH is smaller than the one for DAI, and there is equal demand for both, then the lending interest rate for ETH will be higher than the one for DAI, incentivizing users to lend their ETH to the protocol.

While this is an improvement with respect to the usually slow-changing interest rates of CeFi, which can’t respond to the market demands as quickly, it also means that it’s necessary to constantly keep up to date on the rates if you want the highest yield. It also applies to the borrowing interest, so you need to keep track of the changes so that you know how much interest you will need to pay back. If you want to take a more hands-off approach to borrowing, Aave also offers a stable borrow APR, which doesn’t change in the short term.

As far as the practicalities are concerned, using lending and borrowing dApps is similar to using DEXes. All you need is a wallet and you’re good to go: just go to the dApp website, connect your wallet and choose the token that you want to supply or borrow. Now you should have all the knowledge you need to use lending and borrowing dApps, while at the same time having a good understanding of how they work. Remember to check out the next lesson on some precautions you need to take and you’re good to go!