Getting started with DeFi #2: Borrowing and Lending
Before borrowing and lending in the crypto-economy, it's helpful to understand how things work in our current financial system. You might be surprised.
The myth that only the money printer creates new money
We're currently living in a macro-economic environment where developed economies see inflation rates reach new highs, well above their central bank targets. However, interest rates aren't keeping up with it. Crypto Twitter likes to blame the money printer (1, 2), so much so that someone set up a website for the meme. But is it the primary way new money enters circulation?
Let's explore using Alice's savings.
If Alice had $1000 at the beginning of the year and annual inflation was 7%, her money would have lost $70 in value. The number in her account remains the same, but products become more expensive; hence you can afford less. Instead of 100 Teacups, she can now only buy 93.
Usually, banks offer savers an interest rate on their deposits.
How do banks finance that? In very simple terms: banks don't have to keep everyone's deposits at all times in their treasury. Suppose the bank had the policy to save 10% of all the deposits they receive in reserve. When Alice gave them $1000, they stored $100, while they loaned out $900 to someone else at an interest rate of 5%.
Interestingly, this process, also known as fractional reserve banking, creates new money as the borrower's bank can repeat the process.
“Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.“ Bank of England
In the above scenario, with Alice saving $1000 in her bank account, the bank makes $45. They will pay Alice 2% interest on her deposit ($20) and still profit. Alice has still underperformed inflation. So she might turn to DeFi for alternatives.
Lending and Borrowing in DeFi
Four dApps fall under the lending category out of the top 10 DeFi apps by value locked, according to DeFi Pulse.
Value locked in DeFi describes the amount of money that users have put into these platforms. It’s a concept similar to deposits in a traditional banking context — where one can earn interest or take out loans after adding money to one’s bank account.
The most popular one among leading DeFi apps is Maker, which was created in 2015 and captures nearly 20% of the value locked in DeFi. On Maker, users borrow the stablecoin $DAI, effectively taking out a loan against their cryptocurrency holdings. For more on how the Maker stablecoin works, have a look at our article here.
While lending in the traditional financial system has a long history, reaching as far back as 2000 BCE (farmers in Mesopotamia borrowing seeds issued against a later payment), DeFi lending and borrowing platforms are a more recent invention. And unlike loans in TradFi, there is no centralized entity to broker between parties.
One potential reason for the popularity of DeFi lending platforms are the high interest rates that they offer users, which might attract people like Alice, who are frustrated with under-performing inflation.
But how do these platforms work, and how can they offer such high interest rates, ranging from 5% — 20% on stablecoins?
How does it work?
In a sense, DeFi lending and borrowing platforms are more similar to peer-to-peer lending platforms such as LendingClub, which allow anyone to become a borrower and a lender. Unlike on peer-to-peer lending platforms in the traditional sense, on DeFi lending, Alice might be lending money to an entity or person that she only knows as a 32 string long wallet address; without any further information. Depending on the platform, she might not even know who will use her funds.
All of this is possible thanks to the trustless nature of blockchain and smart contracts. Let's assume that Alice wants to put her $1000 into a DeFi lending platform called BakerDAO. After swapping her dollar for a stablecoin, she heads to the BakerDAO app and deposits her Baker-USD. BakerDAO offers all borrowers a 15% APY (Annual Percentage Yield) on their deposits, financed by lenders taking out loans.
Yet, we're all aware that crypto is highly volatile. While in the traditional financial world, we might agree to give someone a loan as long as they deposit 20% of the loan value as collateral, things work differently in DeFi.
Suppose Bob wanted to take out a loan against his cryptocurrency holdings. He goes to BakerDAO and checks their collateralization ratio. That is the ratio of the loan's value in proportion to what Bob will have to deposit as collateral to take it out. The ratio on BakerDAO is 1.5. So for Bob to take out $1000 worth of loan, he will have to deposit $1500 in crypto assets. On top of that, he will have to pay 15% in interest until he repays the loan. Below is a graphic illustrating the process.
The 15% Bob pays in interest are going to Alice for providing the loan. While in this example, it seems as if two individuals are matched, most platforms will match demand and supply using smart contracts and pooled tokens. So when Bob takes out a bigger loan, he might receive stablecoins that form part of Alice's deposit and other lenders on BakerDAO.
This approach had enabled lending platforms to scale while providing users with liquidity, similar to how DEXs took off when they moved from a pure peer-to-peer approach to a trader-to-pool system.
So far, so good, but you might still wonder
Why does Bob even want a loan?
Taking out a loan in real life is often to finance bigger purchases such as a car or a house. Buyers go to the bank and deposit collateral that covers a part of their loan, but by far not the entire amount.
In DeFi, traders taking out a loan have to over-collateralize, depositing more collateral than the actual loan. What could be the motivation behind doing that? It's not the most capital-efficient way to finance a big purchase. The more likely answer to this question is a combination of conviction and leverage.
Crypto traders tend to strongly believe that the currency they hold will go up in the long run. This is illustrated by the ratio of long to short positions. Any trader in a long position bets on a currency going up, whereas those in short positions believe the opposite will happen. In the below example, we can see that Bitcoin's long positions (green line) volume exceeded short positions (red).
Here are a few reasons why someone might want to take out a crypto loan:
When traders are heavily invested in crypto, they might still need liquidity at times. However, due to conviction, they want to continue HODLing their crypto. Consequently, taking out a loan provides them with liquidity to pay for things without dissolving their crypto holdings.
The main driver behind the rise of crypto lending and borrowing is the idea of leveraging one's position. One way to do that is by opening a margin account with an exchange; another is to borrow money. To illustrate, let's assume Bob holds $1000 worth of crypto — let's call it Alice coin. He believes that this coin will go up so much that he wants to leverage his position.
Bob goes to a lending platform, deposits his $1000 in crypto, and takes $750 in loan. With his loan, he buys more Alice Coins. A few weeks later, Alice coin has appreciated by 50%.
- The Initial collateral of $1000 is now worth $1500.
- The Alice coin bought using the $750 loan is now worth $1,125.
Bob repays his loan of $750 and takes out his Alice Coin. Had he just held onto his Alice Coin, he would have made a profit of $500.
With the loan and the additional Alice coin purchased, he has made $500 + $375. Even if we assume a 10% fee on the loan, he will still have made $300 more profit than without the loan. That's the power of leverage. However, one shouldn't forget that this is a very risky trade.
While the sale of crypto assets is considered a taxable event in most countries, funding and closing a crypto loan isn't. Consequently, some traders will use crypto loans to finance purchases without having to exit their positions and potentially having to pay capital gains tax.
There might be further reasons why someone would want to take out a crypto loan, but the three above are the most common. Yet, so far, we've assumed that crypto will go up.
That's not always the case. Volatility is inherently higher than in other assets. During the most recent downturn, one loan, in particular, caught people's eyes. The trader (7 siblings) had taken borrowed $600 million from Maker, which was at risk of being liquidated.
Liquidations in DeFi are when the collateral for a loan is sold off to recover the loan value. In the above example, because the value of Ether started dropping, so did the collateralization ratio, the ratio of collateral value to loan. A borrower can either add further collateral or close the loan when that happens.
In the case of 7 siblings, they managed to save most of their loan by adding further collateral to their position. However, roughly 65 million worth of ETH were sold off in an auction by the protocol to recover funds (Source).
In traditional markets, this is rarely a problem, but in crypto, prices can fall very fast, so fast that a borrower might end up with collateral that's worth less than the loan they took out. In that case, they have no incentive to close it. If one had to pick between repaying $100 worth of stablecoin to recover $90 worth of collateral, any rational trader would choose the first.
Many borrowing platforms have a liquidation fee to incentivize borrowers to monitor their collateral and ensure that it doesn't fall below a certain threshold. If a borrower's loan ends up being liquidated, they have to pay a fee.
When collateral goes on auction, it often will sell at a discount to market price, which has given rise to so-called "liquidators." These individuals and institutions monitor lending platforms, looking for opportunities to buy collateral at a discount, and turn a profit. They are further incentivized as they receive the fee borrowers have to pay for liquidations. Currently, there are around 132 active validators in the DeFi ecosystem.
While liquidators operate in the background, they are a crucial element of healthy lending markets, as they “save” lenders and maintain the solvency of the market.
Overall, crypto borrowing and lending platforms continue evolving and we might eventually even see under-collateralized loans, more similar to loans we know from traditional finance. Nevertheless, DeFi loans already enable us to take out loans without having to rely on a credit score, nor knowing the borrower which opens a whole new world of opportunities.
A word of caution. Leveraging your positions is always risky. When considering putting money into any lending or borrowing protocol, DYOR, and you might want to pay attention to the resilience of the underlying protocol as well.
During the latest downtrend, traders on Solana had difficulties covering their loans because the network could not scale with demand. In the meantime, other Layer-1 protocols’ fees are becoming more expensive (1, 2), diminishing their perceived edge.
On Minima, the network scales with its demand. This is accomplished by combining two layers into one protocol. The decentralized base-layer for entering, and terminating transaction relationships, and the second layer serves for peer-to-peer interactions, facilitating near-infinite scalability without the danger of high cost.
Once launched, Minima will be a resilient, reliable, and fast ecosystem to foster DeFi innovation, and make borrowing and lending more readily available.