Why to borrow in DeFi?
Since the DeFi boom last summer, the space has seen massive improvements to its core components. Blockchain technology is more in-demand than it’s ever been, and decentralized finance is at the heart of the hype. From automated market makers and staking protocols to DeFi lending and borrowing platforms, the blockchain ecosystem is slowly entering mainstream use, pushing ahead on its journey to mass adoption.
Lending is an essential element of any monetary system, and a strong lending framework is a sign of a healthy economy. Traditionally, loans are given out by banks or other centralized financial services firms with the expectation of getting their money back with some interest over time. Intuitively, centralized lending makes a lot of sense. The bank ensures borrowers pay them back while incentivizing deposits using a guaranteed interest rate. However, in a decentralized system, it’s near impossible to ensure borrowers pay back their dues without some form of collateral.
Lending in DeFi is one of the most popular ways to put digital assets to work. Instead of having a trusted third party to mediate the process, decentralized finance employs smart contracts to handle everything. Smart contracts are essentially snippets of code deployed to the blockchain, and they can be programmed to trigger specific actions after certain conditions are met.
Decentralized lending has all kinds of advantages, including rapid loan processing speeds, fraud analytics and detection, and machine learning algorithms to calculate loan terms and risks. Blockchain’s lending ecosystem is still relatively new, but it allows investors to generate significantly higher returns than deposits in traditional banks. Although to borrow assets, users are usually required to deposit collateral tokens of a higher value than the amount being borrowed.
This ensures borrowers can’t run off with borrowed funds and that lenders are compensated for supplying capital. However, suppose the value of the collateral drops below a predetermined threshold. In that case, the held assets are liquidated to pay the lender back, and though the benefits of lending cryptocurrencies are immediately obvious, the reasons for borrowing in DeFi aren’t as intuitive.
Unlike when banks hand out loans, users usually need to have more capital on hand than the amount they borrow, and this raises the question of why anyone would borrow cryptocurrencies when they could sell their own assets. Lending is only profitable if people are borrowing, and with double and triple-digit APYs becoming increasingly commonplace in the DeFi lending space, it makes one wonder who this capital is being lent to and why.
Despite how counterintuitive DeFi borrowing seems, it brings a myriad of benefits both to investors and the blockchain ecosystem as a whole. Digital assets work great as collateral since they’re far more liquid than, say, a house or a car, and liquidations on lending platforms occur in mere seconds.
It’s easy to see how borrowing less than the collateral locked into the platform seems like a bad deal. For one, the interest rates are absurd. Current borrowing rates range from anywhere between 5 and 25% depending on the protocol, and giving up more valuable assets to borrow assets worth less at such high rates is instinctively a terrible idea.
However, DeFi lending and borrowing platforms don’t exist separate from the rest of the industry, and when coupled with other components of cryptocurrency markets, borrowing can actually put investors at a significant advantage in some instances.
Now let’s see why would Alice borrow in DeFi.✨
The first and most common use case for borrowing is leverage. The concept of leverage is by no means new and has existed in financial markets for decades, giving traders the ability to hold larger positions without possessing the capital upfront. They instead leverage their positions to make larger profits from upward swings and risk heavier losses from bearish movements.
Leverage can be accessed in many forms through cryptocurrency markets, but borrowing assets through DeFi is one of the more straightforward ways of doing it. For example, if someone felt the market was moving up and deposited $1000 worth of ETH to borrow $600 worth of USDT, they could trade it out for $600 of ETH, thereby offering a 1.6x leverage on their initial capital.
Similarly, in bearish markets, traders could deposit stablecoins to borrow ETH and swap it for USDT, buying back ETH at a lower price to repay the loan. In this way, borrowing markets help investors increase their buying power without needing a centralized entity to keep track of who owes who.
2. Hedge Against Risk
Short-selling an investment is one of the most common ways to hedge against risk and involves borrowing the asset in question and selling it, only to repurchase it at a lower price to repay the lender. In cases where the investor already holds the asset, they can minimize losses by recovering some capital from the short-selling gains.
With DeFi borrowing, users can borrow assets directly from the protocol in a trustless manner, hedging risk over their spot investments. In fact, investors can further protect their collateral assets by entering short positions in the derivatives market, so even if the collateral value depreciates to the point of liquidation, the total losses are minimized.
3. Optimizing Taxes
At first, this concept may be hard to grasp, especially for those unfamiliar with cryptocurrency tax laws. Though trading cryptocurrencies isn’t necessarily taxable, converting assets into fiat currency can incur some serious charges. For example, capital gains taxes (CGT) can be as high as 40% depending on the profit made from selling the investment, and selling assets into fiat can even lead to losses depending on how much the asset has appreciated and how much tax is owed.
Cryptocurrency loans, however, do not incur CGT, allowing traders to avoid taxes by only paying interest on the borrowed tokens. Borrowing interest rates may be high, but they’re certainly lower than CGT rates for most people. For example, if someone had to pay 25% tax on the sale of 1 BTC for $40,000 when they had initially purchased the asset at $10,000, they would incur a loss of 0.25 x (40,000–10,000) = $7500 from CGT.
However, if they deposited 0.5 BTC to borrow 10,000 USDT, they could use part of the other 0.5 BTC to repay the loan immediately and would only have to pay the interest rate on the borrowed amount, which at 10% equals $1000 — a fraction of what they would have paid as CGT.
4. Everyday Expenses
Borrowed assets can essentially be viewed as a credit line, and this allows people to use borrowed funds to pay for their daily expenses while keeping their assets safe as collateral. While this use-case only applies if the collateral deposited appreciates over time, with how fast and cheap Layer-2 solutions have become, it’s entirely possible to borrow cryptocurrencies for everyday expenses.
To understand this better, let’s assume a trader had purchased 5 BTC at $20,000, giving him total assets worth $100,000 in Bitcoin. If he deposited 2 BTC as collateral against a DeFi loan, he would receive around $20,000 in USDT (overcollateralized at 50% LTV), which could then be used for his daily purchases.
Now if BTC went up by 20% to $25,000, his total assets would be worth $25,000 x 5 BTC = $125,000. He could then use the extra capital to repay the $10,000 loan with interest while the total value of his assets has risen.
Theoretically, this process can be repeated indefinitely, but there are huge risks involved, especially if the collateral asset depreciates. For example, if BTC instead fell below the threshold limit in the above case, the entire collateral would be liquidated, leaving him with 2 BTC in losses and $10,000 plus interest in debt.
5. Flash Loans
Flash loans are unique to the blockchain space and have no real alternatives in centralized finance. Unlike other forms of DeFi lending, flash loans do not require the borrower to lock up collateral to receive funds — but there’s a catch. The lack of collateral provision doesn’t let the borrower run away with the lender’s money. Instead, the loan is received and repaid in full within a single transaction, or else the transaction fails, and the loan never happens.
Traditionally, receiving and paying off a loan is a long and tedious process. After borrowers receive approval for the loan, they are typically required to pay the sum back through consistent payments over some time. Flash loans are instantaneous, and to be of any use, traders need to call on other smart contracts from the flash loan protocol to perform instant trades with the money before the transaction ends.
However, with the number of flash loan contracts that have been exploited in recent history, there’s still a lot of work to be done before they can go mainstream. This also underscores a broader problem with the DeFi space: smart contracts can be abused if poorly designed.
That being said, flash loans can be helpful in circumstances where traders want to profit from a limited-time arbitrage opportunity. Additionally, they can be used to swap the collateral backing a loan for another token quickly, and they also sustain lower fees since they essentially form a batched transaction.
Lending Blockchain a Hand
A robust lending and borrowing ecosystem affords investors an immense advantage, and with more people entering the space, the benefits appear to be increasing. Lenders receive a steady, high interest rate for providing capital, and borrowers can get access to more money without having to sell their holdings. However, there are inherent risks to both sides of the equation — risks many would consider as total dealbreakers.
Unlike the traditional financial services arena, there are no investor, lender, or borrower protections in place. Instead, the system relies on principles of game theory as its primary means of protection, motivating players to behave per the protocol’s rules by disincentivizing malicious actions instead of enforcing good conduct.
Borrowers aren’t likely to default on loans since they risk losing more than they borrowed, but they are vulnerable to having their collateral hacked, incurring losses for both the lender and the borrower. For the DeFi industry to grow over the next few years, these issues need to be addressed to create a better protection infrastructure for both sides.
Decentralized finance relies heavily on its lending markets, which are some of the biggest reasons for its unprecedented growth over the last couple of years. From hedging risk to optimizing taxes, there are many reasons why someone would borrow digital assets, and as more people dip their toes in the cryptocurrency waters, these more use-cases will evolve to suit user requirements.
Though the world of DeFi seems complex and tedious at first, its progress in recent years shows how close the industry is to be ready for mainstream adoption. Currently, DeFi is more focused on catering to financial use-cases rather than retail ones, but as projects continue to supply innovative products to the space, the demand for lending and borrowing services is only moving up.