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Decentralised finance (DeFi) is disrupting the financial world as we currently know it, ushering in many advantages that are currently unavailable in traditional finance. The benefits of DeFi are endless and highly rewarding, ranging from individual control of finance to decentralisation. This revolution in the financial industry has only been made possible by an underlying technology known as blockchain. Blockchain technology or distributed ledger technology (DLT) is the foundation upon which DeFi and other segments in the cryptocurrency ecosystem rest. To date, the technology is still being applied in several mainstream sectors.
More than ever, blockchain technology has witnessed several applications in the finance industry. One such application is in the field of DeFi loans. Lending has evolved from being under the control of traditional financial institutions to the everyday person, thanks to DeFi.
What Is DeFi?
DeFi is an ecosystem of financial applications operating on blockchain technology without the involvement of a central body like in traditional finance. It adopts a peer-to-peer infrastructure on which decentralised applications or DApps are built. DApps allow people to be involved in making financial decisions themselves, barring third parties in the mould of banks. These DApps offer financial services in an open-source, trustless and transparent environment that has come to be known as a smart contract.
If blockchain technology is the pivot for DeFi, smart contracts are the lever for both DApps and DeFi generally. Although smart contracts are part and parcel of blockchain technology, DeFi leverages their functionalities to create self-executing agreements that facilitate activities such as staking and yield farming, including lending and borrowing. It is on this basis that the world has come to terms with what is now known as DeFi loans or lending.
What Are DeFi Loans?
DeFi lending provides loans in cryptocurrencies. Conversely, in traditional finance, loans are obtained in fiat currencies. Further, the process involved in obtaining loans from traditional institutions is often a herculean one. The paperwork, long duration and the massive interest rates that accrue to such loans are usually a huge turn-off for users. Essentially, loans in DeFi are provided for devoid of the involvement of an intermediary.
DeFi loans are facilitated through the help of blockchain technology and smart contracts. Lending platforms integrate programmable contracts to help users gain access to crypto loans. In this case, there is no paperwork, no legal fees or any additional costs, and loans are obtained in a matter of minutes.
DeFi lending benefits both lenders and borrowers. On lending platforms, borrowers obtain crypto loans from other users like them because the lending protocols use a peer-to-peer network that digital contracts preserve. These contracts are written in codes that are executed once both parties – the lender and the borrower – have fulfilled certain conditions. Lenders provide crypto loans by depositing a crypto coin or token supported by a lending protocol, and in return, they earn interest when users borrow such loans.
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How DeFi Lending Works
Although holding crypto assets as a long-term investor may have its benefits, the risks are quite high given the volatile nature of digital currencies. Therefore, instead of leaving these assets idle in their wallets, most crypto investors often move them into DeFi protocols to escape volatility. In these protocols, they partake in staking or yield farming and earn rewards for providing liquidity with their crypto holdings. In other cases, they transfer their holdings to lending protocols where they can take advantage of the decentralised infrastructure to benefit from their crypto assets.
How DeFi Loans Benefit Lenders
Lending platforms are designed in such a way that anyone can be a lender and on their terms. There are a host of other perks as well, including higher interest rates and control over their funds. The crypto assets of lenders are accumulated in a lending pool a smart contract controls, from which borrowers are allowed to obtain loans after depositing collateral in the form of a different crypto asset, often more valuable than the asset they intend to borrow. At other times, the collateral may be equivalent in value to the borrowed asset. This sharply contrasts with the loan process in mainstream finance where physical property is used as collateral.
How Borrowers Benefit from DeFi Loans
Drawing from the above, borrowers, rather than selling the crypto asset in their custody to get liquidity or to buy the asset they are willing to borrow, offer it as collateral in return for the latter. As such, they avoid the risk of selling the crypto asset used as collateral, only to buy it back later, possibly at a higher price. For instance, if a user intends to borrow one bitcoin and cannot afford to sell the stablecoin DAI in their possession, they would have to deposit the price of one bitcoin in DAI as collateral.
Some lending protocols require borrowers to over-collateralise their loans by depositing an amount that is a minimum of 150% of the loan value, which means if a borrower wants to obtain 100 DAI as a loan, they have to collateralise the borrowed amount with $150 in Ether (ETH). In a worst-case scenario, if the collateral declines below $150 ETH, the borrower will most likely face a liquidation penalty.
Lenders are usually given an equivalent number of tokens to hold in return for their deposits. On leading lending protocols like AAVE and Compound, lenders receive aTokens and cTokens, respectively, which are equal in value to the token that they deposited. These protocols also have other native tokens that contribute immensely to the DeFi lending ecosystem.
DeFi Lending and the Algorand Blockchain
The Ethereum blockchain birthed the DeFi frontier before other blockchains began to latch on to the trend. Launched in 2019, the next-generation blockchain Algorand has helped in pivoting DeFi in terms of providing a platform that is enabling developers to build and launch DApps that are highly scalable, secure and cost-efficient. For DeFi lending and borrowing, some DApps have been able to leverage and adopt the Algorand protocol and its pure proof-of-stake (PPoS) consensus mechanism. These include Algofi and Folks Finance, both of which are providing users with passive means to earn from their crypto assets by lending the assets or borrowing other assets while they present the one in their custody as collateral.
How Algorand Benefits Lending Protocols
One of the benefits that the Algorand blockchain offers DApps is lending protocols that are unlimited. Algorand’s PPoS mechanism is ideal for validating transactions on the network. It also addresses the blockchain trilemma – the concept that no existing blockchain is scalable, secured and decentralised simultaneously. Integrating features such as atomic transfers, rekeying, standard asset tokenisation and Layer 1 (on-chain) and Layer 2 (off-chain) smart contract options, Algorand provides a great platform to design DeFi solutions.
What makes Algorand an ideal platform for building DApps is that it is a green blockchain, meaning unlike the proof-of-work (PoW) consensus that requires a high amount of energy provided by miners on the networks using the model, Algorand’s PPoS infrastructure supports a carbon-negative method of confirming transactions on the network. With rising concerns over the environmental damage that PoW blockchains are causing through excess carbon production, green or carbon-negative blockchains like Algorand are poised to become leading blockchains facilitating DeFi lending among other utilities.
Conclusion
DeFi lending is a major contributor to the rising total value locked in DeFi protocols, which as of September 2021 was nearing $200 billion. It has proven its mettle as a deal-breaker for traditional finance, including banking institutions, by decentralising core financial services like payments, trading, investments and insurance.
While the sector continues to show more prospects, certain issues within the blockchain ecosystem have slowed its adoption. Notwithstanding, in recent times, we have witnessed the advent of several solutions to solve these issues, including the proposed transition of the Ethereum blockchain from the PoW to the proof-of-stake consensus model. This may be the catalyst that would drive DeFi to the zenith, not leaving out lending protocols.
