Decentralized finance or “DeFi” is a financial phenomenon that has gained exponential popularity over the past two years. DeFi has been the subject of much debate and attention within the global crypto start-up community, spurring the production of many innovative projects. DeFi is particularly promising in the field of lending, where it has the opportunity to fundamentally change the way liquidity is lent and borrowed. In this article, we will explore the key differences between “traditional” lending via banks and the more innovative DeFi lending.
So first, what is decentralized finance?
The term “DeFi” describes the use of decentralized technology to power financial services operating along the blockchain. This revolutionary field eliminates centralized processes between intermediaries and breaks geographical boundaries.
DeFi applications, called “DApps”, have a wide range of uses including information recording (such as distributed ledgers), consensus mechanisms, and decentralized decision-making. As a whole, DeFi protocols improve efficiency and reduce costs, thus making financial services more accessible to all.
What is decentralized finance lending?
On September 1, 2020, a total of more than 9.12 billion USD was locked into DeFi projects.
Most of these funds are contained in lending protocols, in which DeFi users earn interest for supplying funds (or, conversely, pay interest for borrowing funds) in a trustless and non-custodial manner. Many protocols exist fulfilling this specific function.
These decentralized lending protocols are essentially automated money markets. Traditional money markets are seen as low-risk, short-term investments in debt. In this way, the old markets are no different from the new markets being formed through decentralized protocols. However, the insurance of credits and other factors differ enormously between the two fields.
Decentralized lending is different from traditional, bank-based lending in the following ways:
1. Banks are eliminated.
In the classic Intermediation of Loanable Funds (ILF) model of banking, banks served as intermediaries arranging loans between savers and borrowers.
Now, rather than acting as intermediaries loaning out real savings, today’s banks act as money creators, and so are limited by their profitability and solvency requirements. Consequently, profitable ideas often do not receive financing because they did not reach the requirements set by the bank. In addition to this limitation, banks’ processes are usually opaque, inefficient, and resultantly expensive for everyone involved in this market.
DeFi lending protocols can offer a solution to these issues; through the conditions and processes set out in smart contacts, DeFi lending protocols are able to serve as intermediaries between borrowers and savers. Furthermore, these protocols do not reject financing if a user wants to lend or borrow at the specified conditions. Because they utilize blockchain technology and eliminate the need for a bank or traditional banking processes, DeFi lending protocols are automated, efficient, and cost-effective for their users.
2. Transparency generates trust.
In traditional lending, a bank’s internal scoring system decides whether to accept or reject a loan. There is little transparency in this process; the structure of this valuation is usually not known to the saver or borrower. To those not intricately versed in finance, many other bank lending process are also opaque. This can lead to a lack of trust towards the bank.
In contrast, DeFi lending is inherently transparent, since all DApp decisions are made on the basis of smart contacts. These algorithms are stored and processed openly, and are easily accessible on the network. Anyone can view them to verify the mathematical calculations for interest rate, mortgage amount, and other values.
As such, transparency leads to more trust in DeFi protocols and more security for all participants.
3. Overcollateralization promotes stability.
This improved security is also important for minimizing the risk to individuals financing the loan.
In a traditional bank, the owner of a checking or savings account has only limited influence on the risk of the loan decisions his or her bank makes. According to its scoring system, the bank decides whether or not to issue a loan and which collateral must be put up. Usually, the loans are undercollateralized rather than overcollateralized, which leads to an increased risk for the actual supplier of the money who, in case of insolvency, will never get their money back.
In contrast, DeFi lending minimizes the risks of overcollateralization. Depending on the particular protocol, borrowers must deposit up to 150 percent of the loan amount as collateral. The DeFi protocol then acts like a pawnshop by managing cryptocurrency as collateral for other liquidity, thus minimizing the risk for the lender. Furthermore, this increases the liquidity and stability of the DeFi protocol.
4. Assets are preserved, not liquidated.
In addition to being beneficial to the lender and DeFi protocol, this pawn shop-like structure is also beneficial to the borrower.
In traditional bank-based lending, the value of assets must be rigorously assessed before they can serve as collateral to a loan. A certain portion of the credit may also be required by the bank as a prepayment, meaning that assets must be liquidated.
In contrast, with DeFi lending, there is no need for a complex valuation of assets, as cryptocurrencies can be accepted as collateral at their current exchange rate. A down payment is also not required, since DeFi loans must be overcollateralized.
5. Global flexibility is prioritized over local ties.
One of the most important arguments for DeFi lending is its global availability.
Acquiring a bank loan usually necessitates that an individual physically visits a bank office. A permanent residence and official documents of the country in which the bank is based are also needed. Additionally, the bank requires a certain consumer credit score to agree to grant a loan.
With DeFi lending, all of this is no longer necessary. Loans can be applied for and granted from anywhere in the world via the Internet. It does not matter where you come from, who you are, or what you do, as long as you can deposit the needed collateral.
Therefore, DeFi lending is much more accessible than a classic bank loan, especially for business ideas and micro credits in developing countries.
DeFi lending has a multitude of advantages over bank-based lending, all of which result in increased trust and accessibility.
Thus, lending DApps will become increasingly popular, as consumers realize they are more attractive than traditional bank loans.