Lending & Borrowing in TradFi

In traditional finance, most borrowing and lending is done through banks. People apply to borrow funds and go through an extensive due diligence process from the banks from which they are evaluated on their creditworthiness, financial healthiness, and future loan repayment abilities. Loans are extremely helpful in allowing people to access opportunities they otherwise wouldn’t be able to afford, but there are a few issues.

• Poor credit scores can cause irreparable damage
• Predatory lending practices may take advantage of certain people who will never be able to pay off their loans
• Banks act as an intermediary and dictate the interest rates with zero transparency for the borrowers; banks also take a majority of the interest rates earned from the borrowers and return minimum to their depositors
• People will often use assets they cannot afford to lose as collateral, like their homes

Lending & Borrowing in DeFi

In decentralized finance, lending and borrowing is made possible through the use of smart contracts. DeFi protocols like Umee allow anyone with crypto assets and an internet connection to participate in lending and borrowing. Blockchain technology and its decentralized nature allow lending and borrowing to be done in a transparent, trustless, accessible, permissionless, and efficient manner; DeFi essentially allows crypto users to be their own banks.

In DeFi:

• Depositors i.e. lenders typically receive significantly higher interest for the assets they’ve deposited when compared to a traditional bank
• Lenders can deposit and withdraw at any time
• Borrowers are not subject to credit checks
• Borrowers are not subject to mandatory periodic payments
• Borrowers have the ability to continue earning interest on the collateral they deposit
• Borrowers are currently unable to use physical assets as borrowing collateral
• Interest rates are usually determined algorithmically based on supply and demand

How does it work?

When a DeFi user makes a deposit through a protocol like Umee, they’re adding liquidity to a pool that is used by other borrowers. This means that depositors earn lending interest on their deposits and have the ability to use these deposits as borrowing collateral without sacrificing the lending interest being earned.

In order to allow people to borrow assets in a trustless manner, DeFi protocols require borrowers to provide collateral in the form of another crypto asset. To ensure the loan plus interest can be paid off in full, borrowers typically have to provide collateral with a higher value than the total amount they can borrow.

After DeFi users have deposited their collateral, they can choose which asset(s) they’d like to borrow. Different assets require different levels of over-collateralization to borrow based on things like asset risk profile, historical price volatility, trading volume, and the market cap of the asset being borrowed.

DeFi borrowers are expected to pay the entire loan plus interest in the form of the asset borrowed in order to redeem the collateral. There is no specific date the loan must be paid off, nor are there mandatory periodic interest payments. Borrowers can also choose to pay off the loan partially to deleverage their positions in volatile market conditions, for example. Once borrowers have repaid their loan in full plus the interest owed, they have the ability to withdraw all of their collateral.

When DeFi borrowers take out a loan it’s important that they monitor the health of their position, or they risk being liquidated. Many protocols will use things like loan to value ratios to represent the health of loans. A loan to value ratio represents the value of the asset borrowed against the value of the collateral deposited, in terms of the asset borrowed. If borrowers’ loan to value ratios climb above a predetermined threshold, they will be flagged for liquidation.

When borrowers are liquidated, the assets they provided as collateral are auctioned off at a discount so that they sell instantly. This process is in place to ensure that under-collateralized loans are completely paid off, especially in times of extreme market volatility. For this reason, liquidated borrowers are no longer able to withdraw their collateral by repaying their loan plus interest; instead, they are left with the loan proceeds they initially accessed through borrowing without having the duty to repay.

A few steps borrowers can take to minimize their chances of being liquidated include:

• Borrowing smaller amounts relative to collateral provided
• Depositing more collateral as the loan to value ratio becomes less healthy
• Making payments on the loan as the loan to value ratio becomes less healthy

Conclusion

In conclusion, DeFi lending and borrowing provides several advantages over traditional lending and borrowing. It may seem a bit overwhelming at first, but I encourage you to experiment with DeFi protocols like Umee, once launched, to gain a better understanding. If you’re completely new to crypto, I recommend starting with a relatively small amount of money and seeing where it takes you.

In future posts, I’ll explain how different types of DeFi users can utilize these protocols to their advantage. In the meantime, check out the Umee documentation to learn about the benefits Umee will provide for DeFi users. If you have any questions about this article or suggestions for future educational content, hop on the Umee Discord and share your thoughts!