Lending and Borrowing Protocols in DeFi

Introduction

In the world of finance, lending and borrowing represent fundamental services, integral to the functionality of banks and other financial institutions.

With the advent of blockchain technology and its subsequent rise, developers have successfully created analogous lending and borrowing protocols in Decentralized Finance (DeFi). Here, transactions are as simple as connecting one's digital wallet and interacting with an application, eliminating any traditional bureaucratic processes.

In traditional finance, prospective loan seekers must engage in a series of steps, including contacting the bank, completing numerous forms, providing requisite documentation, and then awaiting a comprehensive review from compliance and credit analysis teams. This procedure can be time-consuming, often lasting days, weeks, or even months.

In stark contrast, DeFi streamlines this process, with loans approved and issued within mere seconds, with no intermediaries, all facilitated by a protocol's smart contracts.
    
However, without a centralized authority overseeing these protocols, the question arises - how does one receive a loan? The solution hinges on the concept of a liquidity pool, where lenders deposit capital and earn interest, thus providing liquidity to the protocol.

How Lending/Borrowing Works in DeFi

To function effectively, a DeFi protocol requires liquidity. In this context, lenders deposit cryptocurrency assets into a Liquidity Pool. The interest accrued is dependent on the type of liquidity pool and is calculated algorithmically, reflecting market supply and demand dynamics.

When loan demand escalates, the interest rate correspondingly increases. This rise incentivizes more liquidity providers to cater to the demand.

For borrowers, the procedure is relatively straightforward - deposit collateral and receive the borrowed assets against it. The entire process takes only a few seconds, with no need for personal information and no prolonged waiting times.

Nevertheless, DeFi systems currently require borrowers to be fully collateralized to ensure the protocols' sustainability. Despite this requisite, DeFi lending and borrowing present numerous advantages and facilitate a wide range of financial scenarios.

Type of Users Interacting with DeFi Protocols

The primary users of DeFi protocols are traders and yield farmers, exploiting the unique advantages offered by these platforms. This means that Lending/Borrowing is still a very specific sector, in a development phase.

The main reason why traders operate on DeFi protocols is to access leverage on their operations.

For instance, an investor feeling bullish on ETH can deposit ETH as collateral, borrow USDC or other tokens, and then trade these borrowed assets for more ETH, expanding his long ETH position.

While increased leverage can amplify profits, it also escalates the risk of a margin call if the collateral's value diminishes significantly. In such cases, the protocol will automatically request additional collateral. If the trader fails to provide additional collateral and the price continues to decline, reaching the liquidation price, the position gets terminated, leading to the loss of the deposited collateral.

Although fully collateralized, the borrower doesn’t receive the assets in a 1:1 ratio. The amount depends on the protocol, some of them use it in a 1.5:1, which means that you have to deposit U$150 to receive U$100 worth of the asset, for example.

Moreover, blockchain technology has led to the recent creation of flash loans, which are primarily used by high-frequency traders. These are unique loan types where the capital is both borrowed and repaid in the same transaction, without the need for collateral.

Top Lending and Borrowing protocols

Aave

Established as one of the most popular lending and borrowing protocols, Aave was first introduced in 2017 by the name of “ETHLend”. Later, in 2018, they were rebranded as Aave. By the time of writing, the protocol has a TVL of U$5 Billion, according to DeFiLlama.

Aave allows lenders to deposit assets into liquidity pools and receive interest in the form of aTokens (Aave tokens), such as aETH, which is a synthetic token pegged to the ETH value, issued by the Aave protocol. Borrowers deposit assets as collateral and borrow against these from a preferred cryptocurrency.

The protocol also features its own token, AAVE, enabling holders to participate in voting and proposing changes within the ecosystem. Also, AAVE borrowers do not get charged a fee if they take out loans, and if they use AAVE as collateral to borrow other tokens, they receive discounts on the fees.

Maker DAO

Based on the Ethereum blockchain, MakerDAO is the biggest lending protocol according to DeFiLlama, with a TVL of U$7 Billion.

MakerDAO differentiates by its borrowing mechanism that is exclusively limited to DAI tokens, an algorithm stablecoin pegged to the US Dollar. The protocol issues two types of tokens: DAI and MKR. MKR tokens confer governance rights to the holders and serve as the medium for borrowing fees.

Compound

Another noteworthy protocol is Compound, launched in 2018 on the Ethereum blockchain, and since widely used in the DeFi space. The protocol has today U$1.9 Billion of TVL, according to DeFiLlama.

Compound is very similar to Aave: when lending assets to a pool, lenders receive interest paid in cTokens. The collateral and borrowing ratio is different for each asset, but it usually ranges between 50% to 75%, different from MakerDAO.

The protocol also issues COMP tokens, empowering holders with voting rights and the ability to propose ecosystem modifications.

Conclusion

DeFi Lending and Borrowing protocols are increasingly used by traders, conquering a considerable share of the market, as it corresponds to one of the main activities in traditional finance.

Even though it's an evolving sector, there's plenty of room for growth. Flash loans were unheard of a few years ago, and today they're a significant part of the crypto landscape, especially by arbitrage trading firms, which put a lot of capital inside the ecosystem.

Many other inventions could be introduced to the market in the next years and perhaps completely revolutionize finance!

• Compound's user growth in 2020