Elk Academy Lesson 6: DeFi Lending & Borrowing
Greetings, young Elkemists! If you’ve made it this far, you’ve doubtless grown so confident in your understanding of DeFi that you are starting to discover your own personal strategies for liquidity mining, yield farming, and auto-compounding, all while minimizing risks like impermanent loss. Bravo!
Today, we’ll examine how you can leverage your portfolio even further through simple DeFi lending and borrowing strategies. Loans are a basic concept as old as money itself that play a key role in traditional financial systems. A lender (a bank) provides a borrower (you) with funds in exchange for an agreed upon interest rate.
You may not have realized it, but a savings account works much the same way, except that the roles are reversed: you are lending your money to the bank, who in turn is able to invest it, which is how they can pay you interest on your deposit.
How DeFi Lending Works
DeFi lending follows a similar principle but in a decentralized way, such that users become lenders and borrowers to each other. There is one crucial difference, however: all of the lending and borrowing are routed through smart contracts rather than a broker.
DeFi platforms, like FilDA, that specialize in lending and borrowing services facilitate the process through two-sided smart contracts. Users become “lenders” by staking tokens in the contract, which creates the funds that “borrowers” are able to access as loans.
The lender typically earns interest in the form of the protocol token (i.e. $FILDA). The borrowing side is slightly more complicated. Given the trustless environment, the smart contracts are designed to make it impossible for the borrower to default (i.e. fail to repay) on their loan.
In traditional lending, borrowers typically have to supply some form of collateral — generally some predetermined percentage of the loan — in order to protect the lender if the borrower defaults. In DeFi lending, however, loans are “over-collateralized,” which means that the borrower is required to deposit more funds than she plans to borrow.
Uses for DeFi Lending & Borrowing
Now, you are probably asking yourself: why would anyone do this? If they have the available capital, what is the point of taking out a loan?
Well, there are a few cases where this might make sense. While the value of collateral must exceed the amount being borrowed, the tokens used for collateral differ from those issued for the loan.
If you think that your token will appreciate in value over the short term, and you don’t want to sell it or deposit into a liquidity pool that will result in impermanent loss, borrowing provides a means of preserving your collateralized tokens while freeing up funds to use for other purposes. Since crypto transactions are subject to capital gains tax, DeFi borrowing also provides a way to avoid having to pay short-term capital gains.
There are more complex strategies too. For example, you could use borrowing to “short the market,” seeking to profit when an asset goes down in price. In this scenario, you would borrow the token you anticipate will drop and use it to buy a stablecoin. If you are right, and the loaned asset decreases in price, you can buy it back at a lower price (enough to pay back the loan) and pocket the difference.
Collateral Factors
Not all tokens are created equal. For this reason, lending protocols limit the tokens that can be provided as collateral. They also assign a “collateral factor” to tokens based on the perceived strength of that token, which determines how much you can borrow against that token. A blue chip token like $ETH or a stablecoin might carry a high collateral factor, allowing you to borrow up to 90% against your deposit, while less secure tokens may only let you borrow 50%.
Risks of DeFi Lending & Borrowing
Since DeFi loans are over-collateralized, other than the usual threats of hacks and contract vulnerabilities, the risks to lenders is actually quite low. There is one concern for borrowers to consider, however, which is that the interest rate on DeFi loans is variable, since it is based on the ratio of supplied and borrowed tokens.
This means that if market conditions change abruptly, interest rates can change quickly, meaning that the borrower may have to repay back quite a bit more than they initially expected. The surest way to avoid that kind of situation as a borrower is to monitor the rates of your loan regularly. Interestingly, under the right conditions this dynamic can also work in your favor, such that the supply and demand ratio results in a negative interest rate. In a situation, you are actually earning interest through your loan!
DeFi Lending and borrowing is not for everybody, but if used well, it can open up new avenues to compliment your overall portfolio strategy. If you’re curious, the best way to see how it might be useful is to give it a try!
