Why DeFi loans in crypto ecosystem are growing fast? Back in time, when you thought of taking out a loan for whatever reasons, you were given only a few options such as personal loans and a few specific dedicated loans such as home loans, auto loans, education loans and a few others.
Now, with the advancement of technology and development in the financial system mainly due to the advent of alternative asset classes, you get other forms of loans such as crypto loans, DeFi loans and more.
These loans are easily accessible, fast to get, and are growing fast in terms of popularity and utility.
It is a good way to earn some passive income instead of holding the coins simply in the wallets.
And, the borrowers simply have to pledge collateral to get it.
The best thing about DeFi loans is that you do not need to disclose your identity or have a good credit score to get them, much unlike the traditional loans offered by the banks and other financial institutions.
However, there are downsides of it. Sometimes the collateral to put in is more than the value of the loan.
This is required to protect against fluctuations in price.
This article explores them all and discusses the future of this promising piece of technology in comparison to the conventional form of finance.
If you are ignorant about it, read on to be more knowledgeable.
Why DeFi Loans in Crypto Ecosystem are Growing Fast?
A DeFi loan is one such financial product or service offered by porting it over to the blockchain.
As you may know, the potential of blockchain technology is quite intriguing and has been the most important topic of interest for businesses all over the world, especially those in the financial sector.
They have been the frontrunners in harnessing the power of this innovative technology to reap maximum benefits out of it.
Typically, it is the blockchain technology that has played an important role in developing a varied range of financial services including and not limited to crypto trading, storage, online payments, and now, the DeFi loans.
This particular type of loans have been garnering a lot of attention in recent times and amassing a huge amount of capital at the same time.
According to a report, there are assets worth more than $20 billion locked in different DeFi protocols.
This shows that the level of interest and number of DeFi applications has risen by a significant margin.
Among all other DeFi applications, the Decentralized Finance loans have gained the spotlight the most.
And, there is no doubt that DeFi lending has found and even improved its status quo.
There are several popular platforms you will find out there that offers such loans apart from the three largest leaders in it such as:
- Aave, with a total value of $2.82 billion
- Compound, with a total value of $2.64 billion and
- Maker, with a total value of $4.25 billion.
Quite naturally, even with their year-old valuation, these three platforms are the priority choice of the users who are looking for borrowing or lending DeFi tokens.
You will not earn anything by holding them. This is where the DeFi loans are useful.
You can become a lender in the DeFi world and earn interest by lending your crypto assets to other users.
One of the most significant reasons for the fast growth of the DeFi loans and lending platforms is that it offers the highest rate of lending growth.
Apart from that, it also acts as the most significant contributor for locking up the crypto assets.
As said, earlier, the base layer for Decentralized Finance is the smart contracts which executes automatically thereby eliminating the need of an intermediary oversight.
When loans are made by using smart contracts, the users are sometimes allowed to pool their assets and allocate them to the borrowers.
All the rules regarding such lending are written in the contract.
There are lots of ways to lend your crypto assets on a DeFi lending platform but one of the most significant ways to do it is through the lending pools.
These lending pools can be compared with the loan offices associated with a traditional bank.
These loan pools also follow a specific approach to distribute the interest to each of the investors.
Therefore, it is advised that you spend some time on your research so that you ensure that you get involved with a pool as an investor that suits you the most.
The same applies for the borrowers to know the rules for borrowing since these rules may vary depending on the approach of the lending pools.
The traits of the blockchain technology make a DeFi loan account permissionless and more transparent in the open-source financial services system.
Whether you want to take a loan and pay interest or lend your coins to earn interest, you can do it directly on a decentralized platform.
This is the primary reason that it is also called peer to peer lending.
DeFi Lending and Traditional Lending
When you compare DeFi loans with traditional loans you will be able to see clearly for yourself that the DeFi loans have a significant edge over the traditional loans.
This is another reason for its fast-growing popularity.
For example, the underlying technology of the DeFi lending protocols is the more innovative, reliable, and fast blockchain.
In comparison, the traditional loans offered by the traditional banks still rely on the old-school Web 2.0 network.
This means that the DeFi lending platforms utilize all of the unique features of blockchain technology and therefore perform much better in comparison to the traditional lending platforms.
The DeFi platforms are useful to both the lenders as well as the borrowers which is why both look to use these platforms.
- As for the lenders, they can avail the margin trading options while lending their crypto assets to earn higher interest rates and
- As for the borrowers, they can take fiat currency credits at a much lower rate than the traditional loans.
CeFi Lending and DeFi Lending
When it comes to lending or borrowing using crypto, there is another commonly accepted method apart from DeFi loans.
This is when you take out a loan organized by a Centralized Finance institution.
These loans are called CeFi loans, which are quite different from the DeFi loan in spite of the fact that both use crypto assets.
One of the significant differences between a CeFi and a DeFi loan is that, for the most part, the CeFi loans and the lending platforms perform very much like the traditional loans offered by the banks.
For example, an escrowed asset is taken into custody which is lent out ultimately to the third parties such as:
These kinds of loans provide the initial investors with a steady profit.
The CeFi loans look and work very well but only on paper. This is because this particular loan model is susceptible to some specific issues such as:
- Insider trading and more.
On the other hand, the DeFi protocol works in an entirely decentralized environment allowing the users to become either a lender of crypto assets or borrowers of them.
All the time, the individuals are allowed to retain total control over their funds in DeFi.
This is possible because it primarily uses smart contracts that operate on an open blockchain solution such as Ethereum.
The DeFi platforms, much unlike the CeFi platforms, can be used by any user and from anywhere and for that they do not need to submit their personal information and data to any central authority.
Therefore, Decentralized Finance lending is a much better alternative to Centralized Finance lending because the former does not need a central authority to operate.
Some other significant differences between the two forms of lending are:
- Access to CeFi lending is determined by the platform whereas it is permissionless in the case of DeFi lending
- CeFi lending platforms need to follow KYC or Know Your Customer protocols but the DeFi lending platforms have no such necessities
- The custody of funds in CeFi loans is with the platform but in DeFi lending it remains with the users
- The control over the funds is mainly central intermediary but it is not so in the case of DeFi lending and
- The speed of loan disbursement is much slower in the case of the CeFi platforms as compared to DeFi lending.
Therefore, as you can see, the DeFi loans have far better features and are much easier to access provided you have the amount of coins to meet the collateral requirements for the loans.
Reasons to Choose DeFi Lending
Since you have reached so far reading the article, you already know the good reasons to choose DeFi loans instead of the traditional loans or CeFi loans.
Some other good reasons apart from the above are:
- These loans are far more innovative
- These loans offer much more transparency
- These loans are also much more efficient.
Most importantly, the lenders on a DeFi lending platform are allowed to redeem the assets they have deposited at any point in time.
On the other hand, the borrowers are also allowed with the convenience of paying back the borrowed amount either in parts or full.
The working process of DeFi lending platforms is quite easy and fast, and as said earlier, it is the main reason for its rapidly growing popularity and use.
The DeFi loans are easier to access and also offer absolute transparency without the use of any third party intermediary.
The borrowing process is also far more straightforward as compared to traditional lending. All you need to do to get a DeFi loan is:
- Visit a DeFi platform
- Create an account
- Open smart contracts and
- Deposit the collateral in your wallet.
There are no credit checks, no lengthy paperwork or censorship.
In this sort of environment, you get instant approval and payment of funds without any preferential treatment but ensuring complete immutability at the same time.
However, you will need to make sure that the asset you pledge as collateral is at least equal to, if not more valuable than, the loan amount you want to take out.
You can make this deposit in a number of different currencies that are supported by the DeFi lending platform.
When you repay your debt, you get back your original coins deposited as collateral and you are happy that you did not have to sell them off in order to get the loan.
On the other hand, the lending pool or platform is happy because they have earned some interest through the loan which they can now allocate among all of the investors in the pool.
As for the users who want to lend their crypto assets on a DeFi lending platform, they also find the entire process to be quite easy and convenient.
All they have to do in order to become a lender or join the lending pool is deposit their coins using the smart contracts of the DeFi protocol.
The lenders usually receive newly minted coins that are native to the specific DeFi protocol in return as interest on their loan.
These coins given to them represent both the principal amount as well as the interest accrued on the deposited amount.
As said earlier, the lenders are allowed to redeem the tokens any time they want to.
However, the exchange rate of the types of crypto tokens deposited by the borrowers and the native token offered by the DeFi lending platform in the form of interest and principal is typically determined by the APY or the Annual Percentage Yield.
This actually refers to the rate of interest that is decided on the basis of the ratio that exists between the borrowed tokens and the tokens supplied in a particular market.
The collateral requirement in DeFi loans is the most important aspect.
It ideally works on the same principle as the traditional banks that require you to put some collateral to take out a loan as well.
This collateral, in either form, acts as a security deposit basically.
The bank or the DeFi platform may claim it if you are unable to repay the loan.
For example, if you take out a car loan from a bank, the car itself becomes the collateral till you repay the loan in full.
If you do not, the bank can claim the car since it is hypothecated to it.
Similarly, the DeFi lending platforms also require you to put up some coins as collateral if you wish to take out a loan.
This amount required as collateral is often more than the amount you wish to borrow, as said earlier, for specific reasons.
If you fail to repay the debt, the platform has the right to liquidate.
The collateral amount may vary and therefore you are requested to research a bit and find the most suitable one for you before you pledge anything to any DeFi platform.
Therefore, even if lending is anonymous on a decentralized system and there is no physical property involved, you still have to pledge some collateral to take out a loan.
The smart contracts will help in depositing the collateral for your DeFi loan.
Specialties and Challenges
Typically, the DeFi lending platforms offer similar products as any brick and mortar bank or financial institution such as:
- Lending and more.
However, the specialty of the DeFi loans and the lending platforms is that they use the unique blockchain technology to operate.
This makes them so special in ways more than one such as:
- Interest on loan offers
- Lending pools and
- Safety for lenders.
As for the borrowers, they can profit by speculating on the price of the assets that they retain ownership of and pay the loan back as easily as they can avail them.
So, everything in DeFi sounds perfect. Well, not really.
There are a few significant issues and challenges in this form of lending and borrowing that may not be apparent but still exist.
Therefore, there is a high chance that the value of the coins deposited by the lender or taken by the borrower drops significantly.
In such a situation, if the value of the coins held drops below the threshold, your loan may be subject to a penalty due to liquidation.
In order to overcome this issue, the DeFi loans are often over-collateralized, which is an issue by itself.
This is because you pay more as collateral than the amount that you borrow. The reasons to ask for more as collateral are:
- Covering unforeseen expenses
- Avoiding obligatory liquidation of the crypto assets that are likely to appreciate
- Leveraging exposure of a crypto asset for the purpose of speculation and
- Avoiding taxes on capital gains.
All these reasons may seem to be very counterintuitive to you but, sadly, reality is not always fond.
Then there is also the risk of the smart contract or the public code of the DeFi protocol being hacked to exploit the vulnerabilities in it.
Also, there is the risk of human errors especially in typing the wallet address which will result in sending the money to a wrong address and loss of funds, forever.
Types of Rate
There are typically two types of rates on the DeFi lending platforms.
- The interest on deposits or that the investor receives and
- The interest on loans.
The amount of these interests however depends on two specific factors.
The interest on deposits refers to the amount of the loan that depends on the specific type of crypto coin in which the loan is issued and the demand for the coins.
The interest on loans is based on the crypto assets held as collateral.
These interest rates are usually not fixed. For example, the deposit rate will be higher if there are fewer funds available for withdrawal.
Moreover, the rates for different types of service may change many times.
Normally, the interest rates on these loans usually range anywhere between 2% and 10%.
However, specific types of DeFi platforms, such as Aave, may offer unwavering APY in the short term. Still, this fixed APY may also alter if there is extreme liquidity in the short term or notable changes in the demand and supply ratio between the tokens in the long term.
Talking about Aave, one significant and innovative offer of them is the flash loans.
These are specific loans that you can take out without needing to deposit any collateral.
However, the borrowers of such loans are required to use the received funds and repay it in the similar on-chain transactions.
This is quite an efficient solution that may prove to be useful for different purposes such as:
- Instant arbitrage
- Refinancing and
- Portfolio restructuring.
If the borrower fails to repay the loan then the loan along with all transactions made on the chain will be reversed.
Now, you may ask whether or not there is any restriction on the amount you can borrow on the DeFi lending platforms.
Well, the answer to this question is: yes there can be limits on DeFi loans and this cap is typically determined on the basis of two significant factors.
First, it is the amount that is deposited by the lenders in the lending pool of the protocol.
This actually refers to the total funds in the funding pool that is available to the borrowers in a given market.
Second, it is the collateral factor or the quality of the crypto coins put up by the borrower as collateral for the DeFi loan.
This actually refers to the total amount of funds available for borrowing based on the quality of the collateral deposited by the borrowers.
The quality of collateral is however determined by the ‘side factor’ of the crypto coins put up as collateral.
In simple words, the higher the quality factor of the collateral the higher is the amount that can be borrowed.
Moreover, the borrowers can pledge different types of crypto coins as collateral that may have varying collateral factors.
In such situations, the amount of loan to be issued will be determined by the DeFi lending platform on the basis of the collateral factor multiplied by the total amount of the number of the coins.
Usually, as said earlier, the loan amount offered is less than the value of the collateral deposited in order to leave a buffer for the unexpected fluctuations in the price of the coins held.
It is also done to prevent the borrowers from being caught out suddenly by borrowing an amount that is higher than the loan limit.
Usually loan limits and value of collateral are determined by the price feed to evaluate the prices of tokens.
Reliable and major DeFi lending platforms typically use a blended feed of different reliable and major crypto exchanges.
The significant benefits offered by the DeFi loans and the lending platforms have also contributed to the rise in their popularity.
Some of the benefits offered are:
- Better loan origination speed since everything is enabled digitally and cloud-based services without the need of any intermediaries
- Better analytics, machine learning calculations, and fraud detection techniques reduces the risk factors
- Optimized loan terms and execution of loans via e-contracts that offers better reliability in lending decisions
- Better lending rules and credit policies guarantee better services eliminates inconsistency in evaluating loan proposal attributes and ensure better structured deals
- Local, state and federal regulations compliance and better record maintenance of all transactions
- Allowing the borrowers and lenders to make the most out of the lending process which also ensure profitability of the platform
- Better analytics to determine loan duration, loan limits, demographics, credit tiers, loan sources, and more to ensure better loan performance.
- Permissionless access that allows easy availability of loan products from anywhere and anytime
- More transparency of the publicly distributed blockchain network that ensures verified access and rich data analysis
- Immutable architecture of the blockchain network that enhances auditability and security
- Better programmability and execution due to the smart contracts which ensures development of the new digital assets
- Better interoperability due to the interconnected software that complements the DeFi apps and protocols
- Self-custody of the crypto assets and full control over the data of the market participants that ensures higher reliability
- Allow the users to manage their savings in a much better way by channeling them into interest-bearing accounts to maximize their income and profits
- Maintaining anonymity since you do not need to share personal data or disclose your identity in order to get a loan
- Simplicity of the lending process with no paperwork required or bureaucracy to go through to get your loans approved and
- Low percentage of rates ranging between 5% and 8% APY in comparison to loans from a traditional bank that can range anywhere between 20% and 30% on smaller loan amounts.
Therefore, as you can see, the DeFi loans give the lenders and the borrowers a chance to make more profits and provide more freedom in managing the crypto assets.
It is mainly the inclusion of peer to peer transactions that reduces the cost of the loans and at the same time expedites the process of issuing these loans.
No wonder the DeFi loans have grown in popularity so fast with the type of benefits provided and has secured its future in the crypto ecosystem.
Still, the platforms as well as the DeFi products are evolving continually which makes it highly likely that these will be as good as the services provided by the traditional brick and mortar banks.
The promising growth of the DeFi lending protocols and loans will ensure that it offers much better opportunities with the challenges taken care of more effectively.
And, all that can be enjoyed without the need to take help of any third party intermediary while borrowing or lending but with more superior technical perfection.
Therefore, quite naturally, the DeFi loans and lending protocols are gaining a lot of traction from all the participants in the crypto market which include:
- The investors
- The businesses and
- The general public.
Therefore, you too can use the DeFi protocols if you want to make some passive income through a few interesting avenues instead of simply holding your crypto assets in your wallet.
Honestly, there is no good reason to do so, especially when anyone can access and use them simply with an internet connection.
DeFi lending has revolutionized the global economic landscape and therefore you should grab the opportunity since it is offered and has a very bright future.
However, just as it is true with anything related to crypto, using a DeFi lending platform may also be a bit of a roller coaster ride.
Therefore, ensure that you do your due diligence and homework so that you take out a loan or choose a platform that is just right for you.
With such detailed knowledge about DeFi loans gained through this article you will surely be able now to reshape your financial system more easily.
However, as it is with any financial decision, it is good to start with an expert consultation.