Welcome Anon! In today’s topic we will cover lending. Lending is a big part of the market so I figured I would cover the basics here which are fundamental to navigate the lending industry, so be it in crypto or in life.
Decentralized lending have had an explosive growth since 2020, a lot of that includes lending protocols that unlocks capital and enables it to be used more efficiently. The typical boon of a diamond hander is that they don’t want to part with their coins but want to capitalize on its value. Borrowing against your coins have made this a possibility with the general DeFi market cap currently standing at $138B.
As most of you already know, lending is a big part of our economy. Most people think of getting a mortgage when you think of loans. Saving money for a down-payment in order to get access to more capital and buy a desired asset stimulates the economy. This brings us to the question what is actually a loan?
What is a loan?
A loan is simply an amount of money you borrow from a financial intermediary that you pay back over time (normally with interest).
A secured loan is a loan in cash that is tied to your asset. Basically, if you are unable to pay back the loan the issuer can seize the asset to get their money back. E.g your house, your precious digital coins.
These kinds of loans set a maximum loan-to-value (LTV) that you can borrow against. LTV is simply the size of the loan comparison to the asset you are borrowing against. If your house is worth $100,000 (yes I know that is a cheap house) and the maximum LTV is 60% then you can borrow $60,000.
However, we also have unsecured loans. These loans does not require you to have any kind of security. Instead you just borrow an amount and agree to pay it back over a specific amount of time. The amount you can borrow is lower in comparison to a secured loan and determined by how risky the intermediary considers you.
However, as most of the readers know, crypto removes the need for the intermediary. Thanks to smart contracts, it has opened up the possibility of building decentralized applications that can handle lending in a secure way. Instead of having to go through a tedious process involving paperwork. Instead, you can go to a decentralized lending protocol like Aave, click some buttons and deposit some collateral and instantly take a loan against it. Bringing the handling time from days to minutes.
Most people do not have a house to borrow against in this market. Rest assured, your coins will do the job for you. There are different ways you can get some extra leverage in the market (be cautious when you do this and don’t go full degen here if you are new to this).
Undercollateralized loans
An undercollateralized loan is simply a loan that is not fully covered (collateralized). This means that if the loan defaulted, the underlying collateral would not cover the full loan. How does undercollateralized loan take place in DeFi without a bank verifying that you have the capability of repaying instead of running off with the money? This would work through third-party-risk assessment where the third-party trusts the lender completely. Maple Finance is one of the protocols that performs this by allowing undercollateralized loans to institutional players such as Wintermute Trading etc. However, this form of lending is not the standard practice in decentralized lending, which brings us to overcollateralized loans.
Overcollateralized loans
Considering the pseudo-anonymous nature of the industry, overcollateralized loans are the standard of the lending industry in crypto. It forces users to collateralize their loan to a higher value than the loan they will take out of the protocol to hold them accountable to repaying their debt. For instance a protocol like MakerDAO which is one of the most established Decentralized lending protocols in DeFi requires you to collateralize your debt by 150%. Meaning that if you deposit an asset worth 100$ you can loan $50 of the stablecoin DAI against it. This is to ensure users do not run away and that the protocol is profitable despite liquidations. There are other protocols with more favorable collateralization ratio’s out there, which will be covered going forward. As you pay an interest on your loan, on the other side of the transaction are the lenders that deposits crypto assets that can be loaned in returned for interest. This generates a way for lenders to generate passive income on their assets. Instead of tradFi that gives you yields for infants less than 1%. The less said about that, the better.
For the more visual learners, here is a presentation of how it works.
With that covered, the last part brings us to liquidation.
Liquidation
Liquidation in traditional finance is normally connected to companies being insolvent(unable to pay debt) and bankruptcy procedures that forces you to sell assets. In DeFi the smart contract does the job of selling the asset to cover a debt. This can happen when the collateral that you have borrowed against loses too much in value, which leaves you at the risk of liquidation. Along with smart contract risk, this is the highest risk to take into consideration when you are taking out crypto loans. Using highly volatile assets puts you at the risk of liquidation when the market decides to have wild swings. When prices fall below a certain level and liquidation occurs, the DeFi protocols automatically sells the asset, which can lead to cascading liquidations.
Basically, curb that degen itch Anon and don’t play with fire unless you know what you’re doing.
Now with basic lending terminology covered, you are in good stead to look forward to an imminent deep dive into a decentralized lending protocol in the upcoming post.
Author’s Words
I want to clarify that even though I am a finance professional, this is not financial advice, and this article is only meant to bring light to the current market situation. I advise everybody to do their own research, I only want to help you to find what you are looking for. If you enjoyed this piece, feel free to share it and subscribe.