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Decentralized finance (DeFi) lending offers a way to borrow without the common hurdles found with conventional loans. Instead, you can borrow against crypto collateral, giving you instant access to funds.
Business in the DeFi lending category is booming, with an estimated $24.62 billion in total value locked in smart contracts.
DeFi lending refers to using smart contracts, computer programs that run on blockchain networks, to borrow against cryptocurrency collateral. In addition to borrowing, most platforms also support lending, allowing depositors to earn a yield.
Traditional lending bases loan eligibility on a number of factors, often including credit scores, income, debt-to-income, and collateral. By contrast, DeFi lending typically only considers collateral.
There’s also no need to ask a bank or lender for a loan. With a few clicks – and enough crypto collateral – you can borrow instantly. This makes DeFi lending permissionless.
Additionally, there’s no need to explain how you will use the borrowed funds or even provide your name. Your crypto wallet address becomes your identity for the purposes of the loan.
Crypto loans take different forms, including centralized platforms such as Nexo, or decentralized platforms like Aave or Compound Finance.
DeFi lending uses decentralized platforms, meaning there’s no company or management team making the lending decisions.
Instead, DeFi lending uses smart contracts that work the same for everyone, regardless of income, nationality, or other factors. The DeFi lending protocols themselves are often run by the global community, using crypto tokens to vote on proposals.
Let’s say you have 10 ETH and you don’t want to sell your ETH to raise money. As an alternative, you can deposit the ETH on Aave or a similar platform and then borrow against the ETH you deposited as collateral. On Aave, you’ll also earn interest on your deposit. All deposits go into a pool from which borrowers can take loans.
In this example, you’re not limited to borrowing ETH, however. You can use your ETH as collateral and borrow USDT, for instance, a popular stablecoin cryptocurrency that tracks the value of the US dollar.
DeFi lending protocols like Aave don’t require fixed monthly payments. Repay whenever you’re ready, but be aware that the loan continues to accrue interest, which adds to your loan value. It’s also prudent to watch interest rates, which can increase the cost of borrowing if borrowing demand surges.
Loan-to-value (LTV) plays a vital role in DeFi lending. As LTV increases, meaning the value of the loan relative to the collateral value increases, the loan inches closer to liquidation, which is an automatic sale of your collateral.
DeFi lending platforms offer a user-friendly front end to complex smart contracts that make lending and borrowing possible. As a technical matter, the contracts are also accessible without the front end by using third-party tools or custom software if you’re handy at coding.
Popular platforms include:
These platforms let you connect a compatible crypto wallet to deposit funds and then borrow was needed. Many look similar, using an easy-to-navigate two-column design highlighting assets supported for deposits and assets available for borrowing.
To learn how the borrowing process works, let’s use a step-by-step example.
DeFi lending comes with two primary risks: liquidation and hacks. Liquidations can occur if the loan-to-value ratio for the loan exceeds a certain threshold, in which case, your collateral can be sold automatically to cover the loan. Hacks represent another risk for DeFi users because the protocol’s smart contracts themselves become targets, possibly putting user deposits in peril.
DeFi private lending refers to lending protocols that mask the wallet addresses of participants, typically using ZK (zero knowledge) rollups to pass completed transactions back to the Ethereum blockchain. Few DeFi lending projects focus on this approach.
DeFi staking and lending both involve locking tokens in a smart contract, but the goals often differ. Staking typically supports security for a blockchain or protocol while earning a yield. By contrast, in DeFi lending, users deposit crypto tokens into a smart contract to earn interest and use them as collateral for loans.
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Eric Huffman has a diverse background ranging from business management to insurance and personal finance. In recent years, Eric's interest in finance topics and in making personal finance accessible led to a focus on cryptocurrency topics. Eric specializes in crypto, blockchain, and finance guides that make these important topics easier to understand. Publications include Milk Road, Benzinga, CryptoNews.com, Motor Trend, CoverWallet, and others. Always learning, Eric holds several certifications related to crypto and finance, including certificates from the Blockchain Council, Duke University, and SUNY. When he's not writing, you might find Eric teaching karate or exploring the woods.
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