What is a DeFi lending protocol?
Let’s go into its ins and outs.
The constant advances in blockchain technology have enriched its use cases, among which the boom of the DeFi ecosystem pulls in more individuals and organizations. According to DeFi Llama’s stats, DeFi’s TVL has exceeded $190 billion so far, in which the lion’s share is mainly contributed by the Ethereum ecosystem. Efforts made in recent years have led to the emergence of many innovative financial concepts, including stable coins, lending platforms, derivatives, insurances, and payment platforms, further diversifying the financial ecosystem.
In the DeFi sphere, full-fledged products and services mainly include staking and lending, decentralized exchanges (DEX), stable coin assets, and means of payment (such as decentralized wallets), among which lending is one of the most common use cases. Always checking DeFi Llama, lending protocols account for a relatively large proportion in the DeFi ecosystem, with the TVL reaching $ 43 billion. Lending projects mainly prvided basic lending services with stablecoins in the early days and later shifted their focus to new services with targeted use cases such as leveraged yield farming.
Next, Truly will walk you through the key information about DeFi lending protocols. Let’s go!
What are DeFi lending protocols?
Decentralized lending protocols are decentralized platforms that connect lenders and borrowers. These platforms allow borrowers to borrow cryptocurrencies with interest and also allow depositors to deposit cryptocurrencies in exchange for interest. No intermediary is involved throughout the lending process.
In DeFi lending, transactions such as depositing, borrowing, and liquidation will be executed by smart contracts on the blockchain when conditions are met. The automatic code-driven execution process bypasses the redundant manual procedures that are troubling the traditional financial market, including the need for human reviewers, giving everyone access to easy borrowing without having to reveal their identity to a third party. This mechanism also works much more efficiently.
What are the popular DeFi lending protocols? What are their strengths?
When we talk about DeFi lending protocols, the first name coming to our mind will probably be Maker, a flagship in this sphere, followed by other well-known names such as Aave and Compound. A variety of protocols have sprung up to meet the market’s diverse needs. Statistics on DeFi Pulse show that the top five DeFi lending protocols are now Maker, Aave, Compound, InstaDapp, and Liquity, most of which are native to Ethereum.
These top-rated DeFi lending protocols have grown to what they are now on their unique strengths. Today, Truly would like to walk you through Maker, Aave, and Compound, three “big shots” in the world of DeFi lending protocols, to give you some insights into the ways of lending.
1. Maker: Stake Stablecoin to Borrow
The Maker Protocol is one of the largest decentralized applications (dApps) on Ethereum. It allows users to create DAI tokens and borrow with DAI, a stablecoin pegged to the U.S. dollar. Maker is open to everyone worldwide and is not subject to any restrictions or KYC requirements.
2. Aave: Diversified Lending Pool
Aave is another leading DeFi lending protocol. What differentiates Aave from others is that it allows users to earn interest on aTokens that are converted from the deposited assets. Aave also features Flash Loans. As a sophisticated diversified lending pool in the Ethereum ecosystem, Aave hosts a TVL of over $100 million and more than 10 different assets, among which TUSD is a promising stablecoin asset.
3. Compound: Liquidity Pool-Based Loans
Compound is an Ethereum-based open source protocol. By offering an efficient cryptocurrency market driven by its algorithm, it enables a simpler and smoother experience for lenders and borrowers. A Compound pool’s interest rates are determined by its liquidity and will change with the ratio of the funds supplied by lenders to the pool against the loans borrowers wish to take out. As of now, the TVL of TUSD in Compound has reached $88 million, and users can earn interest by depositing TUSD up there.
Each premium DeFi lending protocol has its unique advantages, but they all share the same final goal — to make lending easier and faster. As risks vary among different DeFi lending protocols, users shall take into account the interest rate, risk, and liquidation mechanism of a protocol and get familiar with the DeFi glossary for a better understanding of the protocol’s growth, so as to create a reasonable asset portfolio.
What are the commonly used terms for DeFi lending protocols?
The collateral is used as a guarantee when you borrow money from lending platforms. To borrow assets from a DeFi protocol, you will need to provide some assets as collateral, which usually comes in cryptos in DeFi. If you cannot repay the loan, the protocol will not return the collateral.
2. Collateral factor
It contains risks to use crypto assets, whose prices are not stable, as collateral. When the price of collateral falls, its value may not be sufficient to repay the loan. The collateral factor determines how much money can be borrowed based on the collateral value. For example, the collateral factor of DAI and ETH on Compound is 75%, meaning that a user can only borrow cryptos with up to 75% of the value of the DAI and ETH supplied. Price stability varies between cryptos, and therefore the common practice is to assign different collateral factors to various assets.
The concept of interest in DeFi is no different from that in traditional banking. Typically, there are two types of interest, namely simple interest and compound interest. Interest calculation in DeFi is more complicated, as transactions on Ethereum rely on external triggers, and user actions are needed to trigger interest calculation in DeFi protocols.
To give you an example, though interest calculation on Compound takes place in each block, it is not automatically completed backstage but triggered by crucial user behavior such as deposit, lending, and liquidation. In other words, the DeFi protocol will not execute interest calculation without user action.
4. Price oracle
Price oracle is a common concept in DeFi protocols. When a DeFi protocol handles different assets, it needs to know their current prices. Basically, a price oracle is used to feed asset prices to DeFi protocols.
Price oracle is an integral part of the DeFi ecosystem, but few DeFi users pay attention to how it works. In fact, if not appropriately designed, price oracles might cause serious security loopholes. Generally speaking, if the assets’ prices are under attack, the entire DeFi protocol would fail.
Currently, most DeFi protocols use their own price oracles, so before making overweight investments in these protocols, it is essential to check the code implementation of their oracles and understand how they feed prices. The good news is that Compound has released Open Oracle, which paves the way for standard solutions in this industry. It can work as the price oracle for different DeFi protocols to eliminate potential risks.
Liquidation refers to the cases where the value of your collateral falls close to the amount of your loan or below it, and the DeFi protocol allows others to buy your collateral. Typically, DeFi protocols would incentivize liquidators to perform liquidation timely with rewards, which are called liquidation bonuses or liquidation incentives. This is in the interest of the DeFi protocol as it guarantees timely liquidation before the collateral price falls too much. It is worth noting that once the collateral value falls below the loan amount, there would be no point in borrowers repaying the loan, and neither would the DeFi protocol be able to pay the loan.
Over-collateralization is one of the most frequently used approaches in the DeFi market to transfer asset value to tokens. Essentially, this model requires borrowers to collateralize their assets on lending platforms so as to offer these platforms the ability to transfer credit. This is similar to bank reserves, only that the reserve ratios are lower than 100%. Over-collateralization is a mechanism that protects smart contracts by setting the value of the collateral higher than the value of the loan to reduce the risk of triggering liquidation, which happens when the price of the cryptocurrencies that the borrower has collateralized fluctuate considerably.
These are the terms that might be useful for you. Please leave Truly a message if you want to learn more.
What are the future trends for DeFi lending protocols?
The booming DeFi lending market presents both competition and opportunities. In addition to the support of cutting-edge blockchain technology, DeFi lending protocols should rely more on their own operation mechanism. Currently, liquidity, interest rates, and security are the top priorities in bringing DeFi lending protocols forward, where breakthroughs will be made down the line to break down existing barriers. In the meantime, efforts will be made to innovate the gamut of financial tools and perfect the existing financial system in order to drive the financial world closer to full decentralization, providing users with more smooth, secure, and efficient financial services.