What is Decentralized Lending

2022-05-07 10:03:29

Over recent years, as blockchain infrastructures keep advancing, applications built on top of them have become increasingly diverse. In particular, DeFi has been one of the most trending segments. Apart from the common DEXes, decentralized lending platforms are also essential to the DeFi ecosystem.

 

As one of the most common finance scenarios in our everyday life, lending provides short-term liquidity needed by many companies or individuals. In reality, lending products are heavily dependent on third-party intermediaries such as banks because they require the backing of a reliable credit and guarantee system. While applying for a loan, borrowers (companies or individuals) must go through a complicated, lengthy review process that incorporates identity authentication, credit reviews, assessment of the ability to repay, etc.

 

However, relying on decentralized lending platforms, borrowers and lenders no longer need a centralized institution as the intermediary because funds can be lent/borrowed directly through smart contracts. Using a decentralized lending platform, borrowers only need to provide collateral in exchange for a loan. What this means is that they can get a loan in a very short period, without submitting any personal information or going through a lengthy review process. For lenders, decentralized lending platforms enable them to receive interest simply by depositing assets in the liquidity pool.

 

Most decentralized lending platforms adopt two models. The first is called the stablecoin model. MakerDAO, a typical project adopting the stablecoin model, is one of the earliest decentralized lending products on Ethereum. On MakerDAO, borrowers can use ETH as collateral for DAI, which is a stablecoin anchored to the dollar.

 

On MakerDAO, borrowers must provide collateral of at least 150% the value of the DAI they’re borrowing. If the collateral-loan ratio falls below 150% due to price drops of ETH, then the borrower’s collateral will be liquidated to repay the loan. If the collateral has not been liquidated upon repayment of the loan, the borrower only needs to settle the DAI loan and interest to redeem his/her ETH collateral. MakerDAO could be a great solution for users who believe in the long-term prospect of ETH but are in urgent need of short-term liquidity.

 

The second one is called the liquidity pool model (e.g. Compound and Aave). On Compound, a liquidity pool is created for each type of crypto loans, and deposits, withdrawals, borrowing, and repayment all happen within the pool. Once a user deposits an underlying asset, he/she will receive the corresponding cToken (a deposit certificate determined according to the exchange rate). When the user wants to redeem his/her deposits, the cToken is returned to Compound, and the amount of the underlying asset to be redeemed will be calculated according to the latest exchange rate and returned to the user. For example, if a user deposits 1 ETH at the exchange rate of 1 ETH: 1 cETH, then he/she will get 1 cETH. When the ETH is to be redeemed, assuming that the exchange rate is now 1.5, then the user can get 1.5 ETH for the 1 cETH. In this case, the additional 0.5 ETH is the interest the user earned.

 

Users can start borrowing once they collateralize the assets they have deposited. However, not all assets can be collateralized. For example, USDT cannot be used as collateral. Additionally, ETH, DAI, and USDC all have a collateral factor of 0.75 (75%), which means that users can get a $75 crypto loan (maximum) with a $100 asset. However, once the price of the collateral and the collateral-loan ratio drop, the collateralized assets may be liquidated. Therefore, we do not recommend applying for loans at the collateral factor.

 

Aave uses a similar model to Compound. The only difference is that Aave offers a special feature called flash loans, which allows you to borrow and repay in the same block. What this means is that borrowers can get a loan without any collateral. Flash loans are mainly offered as a free way for developers to get loans.

 

Decentralized lending platforms provide borrowers with the fund they need for arbitrage, leverage, market making, and other activities involved in crypto trades. They have also offered miners and long-term crypto holders more short-term liquidity. For those of you who are interested, why not go to CoinEx Wallet and try out a wide range of decentralized lending products:https://wallet.coinex.com/download

 

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