Brew Money

Chapter 5

Lending and Borrowing in DeFi

Lending is the action of giving capital or an asset for temporary use with the understanding that it will be returned in the future along with an interest payment. Lending and borrowing are one of the oldest economic activities. The first known codified laws around credit were written in The Code of Hammurabi way back in 1800BC.

Traditionally banks act as the facilitators of lending and borrowing. Bank source capital from institutions and consumers. They lend out a portion of these deposits and earn revenues on the spread between the deposit and loan interest rates.

Reserve Ratio or Reserve Requirement defines the portion of deposits that a bank can lend out. Central banks set the Reserve Requirements.

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:

Acceptable Collaterals

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

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.

Interest Rate

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.

Who borrows and why

In the real world economy, individuals and businesses take loans to meet short to long-term capital requirements for use cases ranging from buying a home to expanding a manufacturing facility. In DeFi, people typically take crypto loans for the following reasons:

To maintain price appreciation on crypto assets and unlock their value (liquidating) for daily use without selling them.
DeFi overcollateralized loans enabled traders to do leverage trading and book higher profits.
Crypto gains are taxable income. DeFi lending lets users liquidate crypto assets without paying tax on them.

New innovations in DeFi Lending

The first generation of lending protocols, such as MakerDAO, Aave, and Compound, today manage billions of dollars worth of crypto assets. We have newer protocols emerging with different approaches. For example, Notional Finance allows depositors and borrowers to access fixed interest rates for a pre-defined term. Maple Finance and Clearpool enable under collateralized lending by taking a hybrid approach of DeFi and having KYCed institutions as borrowers.