Lending in a pseudonymous economy
Credits Ratings play a crucial role in enabling lending in traditional finance. A credit rating is an evaluation of the risk of a debtor defaulting on their loan. It is calculated based on factors such as the debtors' repayment history, present debt situation, and macroeconomic conditions.
DeFi is a new ecosystem and pseudonymous by default. This is why credit ratings are still in nascent stages in DeFi. Instead, protocols typically depend on over-collateralization to issue debt.
Lending and borrowing is powered by smart contracts that programmatically issue loans, set interest rates, and manage controls to prevent bad debt.
Potential debtors can lock in their crypto assets as collateral and take out loans from a lending protocol such as MakerDAO, Compound, or Aave.
Example: If a user needs a loan in stablecoins and has $1000 worth of Ether, they can use their Ether as collateral on Aave to avail of a loan of $750 in USDC.
While every lending protocol has its own nuances, a few common parameters that affect lending in DeFi are as follows:
These are assets that the protocol accepts as collateral. Historically, these assets had been crypto tokens that fulfilled the risk criteria set by the protocol governing the community. However, in recent times, protocols such as MakerDAO are experimenting with accepting real-world assets as collaterals. In July 2022, MakerDAO issued a loan of $30 Million to French bank Société Générale in exchange for AAA Rated Bonds as collaterals.
Loan to Value
Loan to Value determines the amount of loan a user can avail of in exchange for a token or asset as collateral. The Protocol governing committees assign a risk rating to different collaterals that decide the Loan to Value. A few factors that determine the rating are how secure they are, what level of maturity they have reached, and at what scale and liquidity they are operating in the market.
Health Factor defines the health of the loan and depends on the current price of the debt asset and the collateralized token. If the health factor falls below a certain threshold, the protocol starts selling the collateral to protect the depositor's funds.
If the collateral value against which the loan has been taken falls beyond a certain point, the protocol sells the collateral to recuperate their costs.
What is liquidation?
Liquidation of a company in traditional finance occurs when it sells its assets at a loss to cover a debt. In DeFi, the liquidation of a user occurs when a smart contract sells their crypto assets at a loss to cover its costs.
The Supply and Borrow interest rates are determined algorithmically basis the available liquidity in a particular token pool and the gap between supply and demand. When the liquidity is low in a pool and there is existing demand for loans, the protocol hikes the rates to incentivise depositors to add more funds and existing debtors to pay their debts. When the reverse happens, the protocol decreases the interest rate.