Decentralized Finance (DeFi) is changing how we think about finance. Among its myriad applications, DeFi lending perhaps tops the charts as one of the most intriguing. With more than $60 billion dollars staked in DeFi protocols alone, it’s obvious that this part of the digital economy is exploding. This article explores the mechanics of DeFi lending and profiles notable platforms. It breaks down the inherent risks, allowing readers to determine if joining in makes sense for their financial objectives and risk appetite.
Understanding DeFi Lending
For these users, DeFi lending platforms are an attractive alternative to traditional financial institutions. They run on principles of accessibility, flexibility and transparency. Unlike traditional lending, DeFi removes banks and other intermediaries, reducing costs and giving users direct control over their funds through smart contracts. This disintermediation removes the requirement of having to trust centralized institutions with a user’s money.
DeFi lending's flexibility is another key advantage. Users can lend their cryptocurrencies, sometimes under terms that are more flexible than conventional loans. DeFi lending, as described above, is permissionless and open-source. This results in a highly transparent financial services environment where any individual can be a participant and audit the underlying code itself.
Of course, one of the biggest draws to DeFi lending is the ability to earn interest. Interest Income Lenders can generate interest income by depositing their crypto assets into lending pools. These APYs can exceed substantially the rates available in other savings accounts or lending platforms. In reality, in some cases they can get as high as 12.3% or even 20%, depending on which platform and which asset class.
Key Players in the DeFi Lending Space
A handful of platforms have established themselves as front runners in the DeFi lending space. Aave, Compound, and Curve are the three most popular, but each platform has its own differentiating features and functionalities.
Of all DeFi lending protocols, Aave is especially known for its advanced interest rate model. Aave’s liquidity interest rate model uses a two segmented piecewise linear function. Under optimal utilization, the curve increases slightly, but at a relatively even rate as utilization grows. Above optimal utilization, the curve increases sharply. The peak efficiency point, usually between 80-95%, is where the curve goes from increasing slowly to steeply. Aave finds variable interest rates by starting with a base rate and two parameters, the slopes of the supply and borrow curves. Base Rate: The minimum interest rate when utilization is 0%. Slope 1: Applied when utilization is below the optimal point. Slope 2: Applied when utilization exceeds the optimal point. Aave is in the process of changing its optimal point for interest rate slope changes from 80% utilization to 90% utilization.
Compound is the second largest player in the Ethereum-based lending market. Similar to Aave, Compound uses an interest rate model that is based on utilization. It dynamically sets the borrowing interest rates based on supply/demand conditions for the underlying assets. Compound functions on a similar principle to Aave, though under different parameters. This results in different interest rates and different market conditions.
Curve focuses primarily on stablecoin swaps and lending. And like Uniswap, it uses automated market makers (AMMs) to provide low-slippage trading between any two assets. Liquidity providers can earn Curve trading fees and interest by supplying liquidity to Curve pools. This combination of characteristics renders debt a truly compelling investment prospect for anyone seeking steady, stable returns.
Navigating the Risks of DeFi Lending
DeFi lending is a promising and exciting new use case, but it’s important to have a clear understanding of the risks involved. These risks, which can be technical in nature or economic, among other avenues, are important to understand in order to make smart deployment decisions.
One of the biggest worries with the new technology is exposing protocols to oracle exploits. Specifically, DeFi lending protocols use price oracles to set the value of assets used as collateral. Attackers can manipulate these oracles to artificially inflate a token’s price. This makes it possible for them to borrow beyond their fair share allocation.
Flash loan attacks represent another significant threat. In these attacks, a malicious actor obtains a flash loan which is repaid in the same transaction. They then fry the market – crash prices – to buy assets on the cheap before very rapidly defaulting on the loan. This can lead to major financial shortfalls for creditors.
Impermanent loss is an often-cited risk of providing liquidity to pools in crypto’s decentralized finance (DeFi) sector, especially in Automated Market Makers (AMMs). The more volatile the assets in a pool, the greater the potential impermanent loss. In order to reduce the risk of impermanent loss, lenders can choose to supply or lend to pools with assets that significantly bounce around a narrower price band. By diversifying lending strategies across different pools and assets, impermanent loss can be mitigated. Feeding liquidity by allowing lenders to earn fees from providing liquidity, these products can partially offset impermanent losses.
Liquidation risk is a concern for borrowers. If their collateral value ever falls below a certain threshold they can be liquidated. As a result, they might be wiped out of their collateral. If a health factor goes below 1 it means eventual liquidation and loss for the borrower is in the cards.
Finally, rug pulls are a common risk that deserves extra mention. In a rug pull, the protocol’s owners or administrators abruptly rug-pull by withdrawing all funds and in turn leaving lenders or investors with major losses.
Is DeFi Lending Right for You?
On balance, whether you should engage with DeFi lending or not depends on thoughtful deliberation on your risk tolerance and economic objective. The promise of triple-digit returns is tempting, but investors need to consider that potential right alongside the risks they’ll find there.
Before diving in, it's crucial to conduct thorough research on the specific protocols and assets you're considering. Gain a better understanding of the mechanisms at play, security protections being developed and deployed, and level of risk that exists. We might advise you to begin with less to learn the ropes and get used to the process.
If you’re someone who is more risk-averse, consider lending in stablecoin. You can search pools by assets with a narrow price band. Taking a multi-protocol, multi-asset approach to diversifying your lending strategies can help further diversify and reduce risk as well.
Overall, DeFi lending has very exciting prospects. It has its fair share of downfalls. Learn to navigate the mechanics, risks, and potential rewards of DeFi. Once armed with this understanding, you can weigh your options and navigate the space with confidence. Keep up with deeper takes from the professionals at ThrowingToken.com. Learn more about DeFi Insurance, Impermanent Loss solutions, detailed DEX reviews, and advanced NFT market analysis to increase your profit.
