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Blockchain Blog 13: Cryptocurrency Lending

In this blog, we will continue the DeFi exploration which we started in the previous blog. But before we start exploring Cryptocurrency Lending, let us talk about Decentralized Gaming.

DeFi Gaming

Decentralized technology has allowed for the creation of decentralized gaming models that challenge the gaming industry as we know it. Today most online games follow a centralized model, where all data is stored on a server that is fully controlled by the game developers. Since the database is owned by a single company, players don’t have real ownership of their accounts and items.

Downsides of the gaming industry today include:
- Technical issues causing server malfunction
- The threat of hackers infiltrating a central system with one point of entry
- Undeserved banning of accounts and IP addresses
- No transparency regarding in-game mechanics and drop rates
- Manipulation of the in-game economy by developers
- The game shutting down and users losing all in-game data

Benefits of Decentralized Gaming

Real ownership: Players can have permanent ownership and full control of their items in-game. Items can be represented as NFTs which can be tradable to other users at any time.
Streamlining payments: Blockchain technology has the power to reduce fees and improve transaction speed. It also can serve as an incentive to make payments directly to developers as opposed to going through multiple middlemen and publishers.
Transparency: The use of blockchain tech allows for the creation of open source and transparent gaming servers. In-game mechanics are known to all users as they can always look it up on the network.
Decentralized marketplaces: Games built on top of blockchain networks can enable the creation of decentralized marketplaces, where players are able to buy, sell, and trade their in-game items directly to one another

Decentraland

Possibly one of the most popular and successful decentralized video games, Decentraland is a blockchain-based virtual world powered by the Ethereum blockchain. Decentraland allows users to build their own games, tools, markets, and content all in a virtual world. It is essentially a decentralized version of Minecraft that functions in a virtual setting. Virtual land in Decentraland is permanently owned by members of the community, which allows them control and ownership over their creations. They can also choose to sell, trade, and buy virtual land and any other creations in Decentraland to other users. Land in Decentraland is coded as a non-fungible, transferable, scarce digital asset (NFT). This technology along with smart contracts facilitates the trade of currency, goods, and services in the virtual setting.

Now more about Decentraland we will talk about when we start exploring Metaverse and NFTs.
We will get back on track to discuss Cryptocurrency Lending.

Cryptocurrency Lending

An entirely new lending market has grown and evolved over the past few years in the cryptocurrency space. Borrowers can opt to use their crypto assets as collateral to receive loans. Lenders can opt to use their crypto assets to fuel loans and receive interest on their investments.

Why Use Crypto Lending Platforms

Imagine a scenario where you needed a loan for a short-term purchase but didn’t have funds easily available. Let’s say you had 5 BTC but you didn’t want to sell it just yet because you expect it to increase in value. If you sell now and the price increases, you will end up with less total BTC when you buyback at the higher prices. Cryptocurrency lending platforms allow users to use their coins as collateral to receive loans typically in the form of a stablecoin (coins based on the value of FIAT)

Some users may opt to “borrow” funds instead of selling their assets to delay paying capital gains taxes on the conversion from crypto to FIAT. Loans taken in the form of cryptocurrency can more easily be transferred to an exchange to trade with.

Crypto loans are paid out in the form of a stablecoin, which is a digital asset fixed to the value of a chosen FIAT currency such as Tether (USDT) or USDC. Loans can also be paid out in crypto assets such as BTC if desired as well.

Crypto Lending Use Cases

● Single asset lending/borrowing
● Non-taxable liquidity
● Rate arbitrage (borrowing on one platform with a low rate and lending it on another with a higher rate)
● Margin trading/Leverage trading
● Flash loans
● Liquidators (running bots to identify loans that have fallen under the collateralization ratio)

Liquidation

Part of the agreement with many lending platforms is the use of collateral, where a user must supply a certain value of capital/asset in order to take out a loan.

An example of a collateralized loan would be where if a user wants to borrow $1000 worth of USDT through the Aave lending protocol. The user would need to supply $1500 worth of an asset (this could be BTC, ETH, or other assets) to cover their loan. If the value of the collateral were to drop below the $1500 valuation, that asset is immediately sold to cover the loan from the lender. This is known as a liquidation event. Each lending platform has different terms regarding the loan to collateral ratio, so make sure that you are aware of all the terms of the agreement before taking out a loan.

Crypto Loan

Centralized Lending Programs

Centralized financial platforms (CeFi) operate similarly to banks. Custody of deposited assets is taken by the bank and loaned out to other clients including hedge funds, market makers, institutional loans, and retail users. Depositors are rewarded with returns based on the size of the investment and the duration of the deposit. It is important to know that most centralized lending platforms have KYC/AML policies that users must follow, meaning that you must provide identification and pass background checks in order to use their services. Examples: ○ BlockFi ○ Celsius ○ Nexo ○ Exchanges such as Binance, KuCoin

Downsides of CeFi Loans

While CeFi lending systems work well, there can be issues such as:
Trust- You have to trust the institution with your funds
Privacy- Personal data is requested when lending or borrowing with CeFi
Theft- The organization could potentially take your deposit and not return it at the end of the agreement
Security- Centralized institutions can be prone to security faults and hack more so than decentralized protocols

DeFi Lending and Borrowing

Decentralized financial (DeFi) lending protocols offer cryptocurrency loans without necessitating a 3rd party in a trustless system. Terms and agreements are encoded on public blockchains such as Ethereum through the use of smart contracts. The digital nature of blockchain tech and smart contracts facilitates the use of these DeFi protocols anywhere in the world without having to entrust personal data to a centralized figure.
Examples of DeFi lending protocols include: ○ AAVE ○ Compound ○ Maker ○ Curve

How DeFi lending protocols work — Lenders

There are two perspectives to consider when understanding lending protocols: lenders and borrowers. People looking to become lenders deposit their assets (coins) into a lending pool powered by smart contracts. Users send their tokens to the smart contract address which holds the coins and facilitates the lending of coins to borrowers. Smart contracts act as an automated intermediary that replaces centralized institutions such as banks in this situation. The smart contract then sends tokens based on accrued interest to the depositors. The tokens that are rewarded are based on the platform used.
Some examples are:
Maker- Maker utilizes the Dai token
AAVE- AAVE utilizes the Token

How DeFi Lending Protocols Work — Borrowers

Most lending programs are considered overcollateralized, where borrowers must offer the lending program an asset equal to or greater than the total amount of the loan itself. This can vary from platform to platform. Let’s say someone wants to borrow $30,000 worth of cryptocurrency and they happen to have 1 BTC and BTC just so happens to be worth $30,000 each. They can deposit their BTC to the lending platform as collateral and they will receive their requested loan. This is usually in the form of stablecoins but can be in the form of BTC or other cryptos. It is important to keep in mind that the value of Bitcoin and cryptocurrency, in general, is still volatile. Situations can arise where the value of the collateral and the loan could increase or decrease during the loan.

Benefits of DeFi Lending

Permissionless: Anyone with cryptocurrency and a wallet can participate in a lending program regardless of where in the world they are in.
Transparency: All information and records are stored on the blockchain used by the lending platform (most commonly Ethereum). Every transaction is visible to the public through the use of blockchain explorers.
Consistency: Access to and use of lending platforms is dictated by the coding used in the smart contracts powering the platform. Human errors when reviewing applicants and creating agreements are removed through the use of automation.
Speed: DeFi lending platforms utilize automated systems for analytics, fraud detection, and other assistance measures when calculating loan terms and risk. This can result in a faster, more streamlined process compared to traditional lending methods.

Loan Limitations

The amount that one could take out as a loan is mainly dependent on the amount of collateral offered. Let’s say someone wanted to use the Compound (COMP) lending platform and wanted to borrow Ethereum (ETH).
○ Ethereum has a 75% collateral factor on Compound, meaning that you can only borrow up to 75% of the value of the collateral you are offering.
○ If you offer $1000 worth of ETH as collateral, you can only borrow $750 worth of ETH.
An important thing to keep in mind is that the total value of the loan must stay under/up to the collateral factor. If ETH has a 75% collateral factor, then your loaned amount must stay under 75% of the value of your collateral.

Interest Returns and Fees

Some interest APYs fluctuate from block to block on the Ethereum network. This means that the rates can change depending on the lending and borrowing demand at the time of the agreement.
○ If there is a greater demand for borrowers then there will be higher incentives for taking out a loan.
○ If there are a lot of borrowers but not enough lenders/liquidity, there may be more incentives for lenders to participate.

This varies from platform to platform. Some interest APYs are stable throughout the loan. Examples of stable APYs are: ○ AAVE ○ Maker

Flash Loans

Flash loans are uncollateralized loans available through DeFi lending platforms.
● A borrower can take out loans without having to use collateral but they have to pay back the full amount in the same transaction it was sent.
● Smart contracts are utilized to ensure that the borrower returns the funds in an immediate fashion. If the borrower does not pay back the loan, smart contracts can roll back the transaction and return the loan to the lender.

This ability to revert loans instantly reduces the risk a lender would take when issuing a loan.
○ No credit score/background checks are required because payment enforcement is automated
○ No limitations to the amount one can borrow in a flash loan.

The Aave lending protocol is the first of the lending services to offer flash loans in the DeFi space. Aave flash loans have one straightforward condition: pay back the loan before the transaction is completed. If this condition isn’t fulfilled, the loan is voided and all transactions made with the loan are voided by default.
Aave flash loans can be broken down into 3 parts:
○ The user borrows tokens from an Aave lending pool
○ The criteria for the loan is fulfilled on the Ethereum blockchain
○ The user must repay the loan plus Aave’s 0.09% service fees.

DeFi Lending Examples

Risks (DeFi)

While DeFi lending may not share the same risks and drawbacks that centralized lending platforms may have, there are important things to keep in mind. Some borrow APYs can fluctuate during a loan period, where the interest rate can dramatically increase resulting in having to pay back more than what was expected.
○ This was seen in 2020 when certain cryptocurrency borrow APYs rose over 40%.
● Collateral value:
○ Borrowers have to ensure that their loan to collateral ratio stays in an acceptable range otherwise they risk having their assets liquidated.
○ This system ensures that lenders do not risk losing their investments.
● The same rules with general wallet and key management apply to the DeFi sector as well.
○ Make sure that you are writing down and saving private key information in secure locations.
○ Make sure that you are entering the correct wallet/address information when transferring funds.
○ There is no customer service to help you if you send your assets to the wrong address.

Impermanent loss: Impermanent loss occurs when the value of an asset locked in a liquidity pool changes after the deposit and results in a loss of value (in FIAT) compared to if the liquidity provider had just held on to the assets without depositing it.
○ This can occur due to liquidity pools changing the values of tokens to maintain a balanced ratio.
Flash loan attacks: Flash loan attacks are simply when malicious users borrow large amounts of capital using flash loans and attempt to manipulate markets or exploit vulnerabilities.
Trust:
○ Although DeFi platforms require significantly less trust compared to centralized entities, you still have to make sure that the creators/teams behind the project are legitimate.
○ Faulty code could be used in the smart contracts behind all the processes that could lead to vulnerabilities and exploits down the line.
○ Unvetted developers could create new tokens and lending platforms to steal funds from once established. It is important to always do your own research on any platform you wish to invest in or utilize.

None of these lending platforms are federally insured institutions. Regulatory risk:
○ Many nations do not have clear guidance on the DeFi sector and cryptocurrency as a whole as of yet.
○ Many DeFi platforms operate without licenses and KYC/AML measures which could be the target of regulators in the future.

Managing DeFi Risk

While there can be risks to using these types of programs, one can always manage the risk taken on in a variety of ways such as:
● Researching the platform and the team behind it. This can involve looking up the team member’s histories and associated projects.
● Reading through the project’s white paper for accuracy and legitimacy.
● Look through the smart contract coding yourself or researching to see if it has been audited by a credible third party.
● Realistic expectations when it comes to returns. Projects boasting incredible returns and APYs that are unmatched should draw up a red flag.

That is all about DeFi for now. We will explore more about the other application of blockchain such as Decentralized Autonomous Organizations (DAO) in the next blog.

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