Crypto lending and borrowing revolutionized the financial landscape by enabling individuals to lend their digital assets and earn interest from them, while borrowers can leverage their existing holdings as collateral to access loans.
These activities occur through decentralized platforms that utilize smart contracts on blockchain networks, eliminating the need for intermediaries. In this decentralized and transparent environment, crypto lending and borrowing offer individuals passive earning opportunities and provide borrowers with liquidity, all in a seamless and efficient manner.
In this article, we'll cover how decentralized lending works, so you can make the most out of OKX DeFi and the growth opportunities provided by decentralized finance.
Lending, borrowing, selling
The advantage of borrowing over selling is that you can get working capital without selling current assets or closing your position. This allows you to maximize the potential gains from a position. For example, if someone holds a significant amount of ETH and believes in its long-term value, they may choose to keep their position open to capture potential increases in value.
They can lock their ETH as collateral and borrow against it, obtaining working capital in the form of stablecoins or other tokens. This way, they can benefit from the potential appreciation of ETH while simultaneously gaining access to liquidity for other needs or trades.
How does DeFi lending and borrowing work?
In DeFi, geography, credit history or identity doesn't matter. The most powerful thing about crypto lending is that any individual can, without intermediaries, take out a loan. Through the creation of money markets, lending and borrowing in crypto becomes a use case, allowing individuals to put their crypto to work to earn interest, beyond letting it sit in their wallets.
DeFi lending and borrowing operate through decentralized platforms and smart contracts on blockchain networks.
Here's a simplified overview of how it works:
1. Deposit for collateral
A user interested in lending or borrowing begins by depositing their digital assets, typically cryptocurrencies, into a lending platform. These assets act as collateral for borrowing or become available for lending.
2. Borrowing
Borrowers can request a loan by specifying the desired amount and the type of collateral they're willing to provide. The lending platform matches borrowers with lenders based on their requirements and loan terms.
3. Collateral locking
To secure the loan, borrowers lock up their chosen collateral, which is held in smart contracts as a form of guarantee. The collateral's value determines the maximum loan amount a borrower can receive.
4. Loan approval
Once the collateral is locked, the smart contract automatically verifies and approves the loan, provided that the borrower's collateral meets the required criteria.
5. Loan disbursement
After approval, the borrowed funds are transferred to the borrower's account. The funds are typically in the form of cryptocurrencies or stablecoins.
6. Loan repayment
Borrowers are expected to repay the loan within a specified timeframe, along with any accrued interest or fees. Failure to repay can result in liquidation of the collateral.
Interest and rewards
Lenders earn interest on their deposited assets, which is determined by factors like the demand for loans and the lending platform's policies. Additionally, some platforms offer rewards or incentives to lenders as a means of encouraging participation.
Smart contract automation
DeFi platforms, like other DApps built on Ethereum, rely on the power of smart contracts to facilitate lending and borrowing activities. Smart contracts are responsible for the automation of loan terms, collateral locking, interest calculations, and repayment schedules. This automation ensures transparency, eliminates the need for intermediaries, and reduces the potential for human error.
A practical example: Aave
According to their official documents, Aave is a decentralized non-custodial liquidity market protocol where users can participate as suppliers or borrowers. Suppliers provide liquidity to the market to earn passively, while borrowers are able to borrow in an overcollateralized (perpetually) or undercollateralized (one-block liquidity) fashion.
A protocol is a program that runs autonomously with a shared set of logic. What it means to be non-custodial is that the platform does not own the assets, and autonomous code locks up the money and moves it by its logic. Meanwhile, permission from a human isn't needed to lend, borrow, or withdraw assets.
With Aave's governance as a DeFi protocol, if you have the AAVE token, you're able to vote on proposals to improve the Aave protocol and how it works.
How do lending, deposits and borrowing work on Aave
Aave aggregates funds that are lent into liquidity pools of the different tokens, which are all smart contracts. Aave uses annual interest rates in the form of APY (Annual Percentage Yield) which gives interest on both the principal and the accrued interest on this principal. With every Ethereum block that passes, interest is accrued.
The smart contract code is audited by third parties, and is open source, with the liquidity pool details verifiable by everyone, unlike the centralized, custodial lending versions of Aave such as Celsius and BlockFi. Interest rates for each pool are determined by algorithms based on that specific token's supply and demand in the ecosystem. Even comparing different stablecoins like USDC and USDT, the interest rates may be different.
Interest rates are low when liquidity is high and there's not much need to incentivize users to supply liquidity to AAVE. Interest rates are high when liquidity is low and lending and repayment needs to be incentivized.
Lending
Lending money to the Aave protocol pools allows a user to earn interest, while allowing others to borrow it. Aave's lending has variable interest rates which adapt in real-time. Lenders are able to withdraw from Aave at any time, without waiting for a loan to mature to withdraw their assets.
Lenders will receive aTokens, such as USDC or USDT, which represents the interest accrued, and can be used for other platforms. If an aToken is transferred to another wallet, that wallet accrues the interest. Lenders earn on their deposits through the interest rate, as well as fees from flash loans.
The interest rate, which is the borrowers' payment for their loans, is related to the borrow rate multiplied by the utilization rate measuring how much is borrowed from the protocol. If the utilization rate is high, the APY would be higher for lenders, since the protocol is incentivized to attract liquidity. Fees from flash loans are a concept created by Aave where lenders and holders of aTokens can receive a revenue share of about 0.09% of the flash loan volume.
Borrowing
Borrowing money from the Aave protocol pools allows a user to use this money on other platforms instantly starting for as short a time as one block, while paying interest on it. Since Aave is a protocol, the advantage is that there's no intermediary negotiation for a loan's maturity date.
The longer the loan is for, the more interest is accrued. Aave borrowing has stable and variable interest rates, and users can switch between Aave collateral-based lending, so users must supply more assets (overcollateralization) to borrow lower than what they supplied from the Aave protocol.
Overcollateralization is protection against aggressive price swings. The loan-to-value (LTV) percentage adapts to market conditions and is the maximum amount of money a user is allowed to borrow based on their collateral. For example, if the LTV for USDC is 85%, then if a user deposits $1000 USDC, they can borrow $850 of any other token.
Health factor
Aave uses a health factor to represent the safety of assets from liquidation. The higher the health factor, the safer the assets are from liquidation. When the health factor is below 1, the collateral of the borrower doesn't cover their loan to debt value, leading to liquidation on Aave. This happens when the borrower's collateral tokens have crashed in value or the tokens borrowed have increased in price. To prevent liquidation, overcollateralization by supplying more collateral assets is important. By keeping the health factor over 2 to be safer from liquidation, a user can also repay part of the loan to increase the health factor.
How can I get started with DeFi?
With OKX DeFi, you can access dozens of lending protocols like Aave, Compound, and Venus all from inside the OKX Wallet. To get started, download the OKX app, switch to wallet, and head over to the Earn tab at the bottom of the screen.
You'll notice there's a search tab at the top of the screen where you can search for staking opportunities based on asset or protocol.
Disclaimer:
THIS ARTICLE IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY. IT IS NOT INTENDED TO PROVIDE ANY INVESTMENT, TAX, OR LEGAL ADVICE, NOR SHOULD IT BE CONSIDERED AN OFFER TO PURCHASE OR SELL OR HOLD DIGITAL ASSETS. DIGITAL ASSET HOLDINGS, INCLUDING STABLECOINS, INVOLVE A HIGH DEGREE OF RISK, CAN FLUCTUATE GREATLY, AND CAN EVEN BECOME WORTHLESS. YOU SHOULD CAREFULLY CONSIDER WHETHER TRADING OR HOLDING DIGITAL ASSETS IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. PLEASE CONSULT YOUR LEGAL/TAX/INVESTMENT PROFESSIONAL FOR QUESTIONS ABOUT YOUR SPECIFIC CIRCUMSTANCES.
