How Does Decentralized Lending Work?

8 min read

Know the difference between borrowing & lending, and risks and rewards of providing liquidity.

At the end of January 2023 there was a little under $50 billion of Total Value Locked (TVL) of capital in DeFi projects.  So what strategies are asset owners employing to increase this asset base and grow it substantially?

If you look at the top 10 categories in DeFiLlama you can see that much of this capital is deployed in protocols in order to:

  • swap/trade cryptocurrency
  • borrow and lend assets
  • stake assets in exchange for a reward

If you own digital assets then obviously the value of these assets may increase/decrease whilst they are in your ownership (except for stablecoins which, in theory, ought to remain stable).  If you are looking to find a way of using your digital assets to generate a return then there are a number of options, including:

Staking - usually refers to the process of participating in transaction validation by committing crypto assets to that network.   This allows you to earn the project’s token by contributing to its Proof of Stake network.

Liquidity Mining - this involves becoming a liquidity provider (LP), (usually, but not always, in pairs like USDC/ETH) to a liquidity pool provided by a DeFi platform.   Other users of the pool can lend or exchange tokens/liquidity in the pool, and when they do so they pay a small fee for each transaction; those fees are accumulated by the pool and distributed as a return to LPs.

Yield Farming - this involves lending your digital assets such as Dai through a dApp, such as Compound (COMP), which then lends coins to borrowers.  The interest earned accrues daily, and you get paid in new COMP coins, which can also appreciate in value. Compound (COMP) and Aave (AAVE) are a couple of the most popular DeFi protocols for yield farming which is a growing sector in the DeFi market.

How Does Borrowing & Lending Work?#

Many DeFi protocols offer an option for people to borrow against their existing cryptocurrency holdings. For example, someone may lock up their ETH as collateral to borrow an amount of a stablecoin. There are a few reasons someone might do this:

  • Tax rules may make borrowing a stablecoin more advantageous than selling a cryptocurrency.
  • The borrower may believe that the currency they're using as collateral is likely to increase in value later, so they don't wish to sell.
  • The borrower may be unable to access fiat loans through the banking system.

With DeFi lending, the borrower's collateral is held in a smart contract. Many loans are over-collateralized, meaning the borrower has to lock up a greater value of their chosen cryptocurrency than the amount of stablecoin they'd like to borrow. This is to cover the lender against any fluctuations in the value of the collateral. If the value of the collateral falls to a specified level, it will be liquidated to cover the loan. The collateral may also be liquidated if the borrower fails to keep up with their repayments.

This system benefits both the lender and the borrower. The borrower is able to access loans without a credit check or ID checks. The lender gets reassurance that they'll get their funds back even if the borrower defaults. Some DeFi platforms use a pool system in which lenders donate liquidity to a pool where the liquidity is distributed/lent to several borrowers. This serves as an additional hedge against defaults and allows smaller lenders to pool resources to participate in loans to larger borrowers.

What Limits How Much You Can Borrow?#

Most DeFi platforms set borrowing limits based on the value of the collateral offered. The collateral required may vary depending on the cryptocurrency the borrower is offering to lock up. For example, a relatively major and well-known currency such as Eth may require a smaller percentage of over-collateralization compared to a less well-known and more volatile token.

What Is Uncollateralized Lending?#

Not all DeFi pools require collateral. Some, such as take a more subjective approach. While they still adhere to the KYC-free ethos of DeFi and lenders can get started very quickly, borrowers are business customers who are asked to provide information about their finances to allow for a form of credit assessment.

Lenders can view the profile of each borrower and make decisions about who to lend to. Rather than loans being made to a pool, the lender loans directly to the borrower. They can choose the interest rate and borrower based on their level of risk appetite.

What Are the Risks of Providing Liquidity?#

One of the most commonly repeated mantras in the cryptocurrency world is "not your keys, not your coins." When you supply liquidity to a DeFi protocol, instead of being your own bank, you're putting your coins or tokens into a wallet controlled by the DeFi pool. This means the coins are no longer under your control.

Some things to consider include:

  • How will you get your capital back out? Is there a time limit or can you withdraw at any time?
  • Is the capital you put in ring-fenced for a specific purpose, or is there some risk of the pool losing those funds?
  • Are you protected against the risk of smart contract exploits?
  • Are you protected against other hacks or attacks against the DeFi provider?
  • How are defaults handled?

Supplying a liquidity pool to a DeFi platform should carry lower risk than locking up money staking on a CeFi platform. However, there is always the risk of a smart contract being hacked or a deliberate rug-pull happening. Unless you have the expertise to evaluate a smart contract yourself before sending funds to it, there's no way to be certain the DeFi platform you work with is completely safe. Choosing a platform which has had its smart contracts audited by a well-known third-party security company is a good starting point.

Smart contracts are still a relatively new concept, and there's a lot to take into account. Not only is there the risk of the contract that holds your funds being exploited, but there's also the risk of a malicious smart contract potentially draining the wallet you connect to it. This is less likely to happen if you take care to only sign smart contracts on trusted platforms and to read all of the transaction details before you sign it. Even so, it's a risk people should be made aware of. Phishing attacks where a hacker creates a fake website that looks a lot like a legitimate platform to trick people into handing over control of their wallets are commonplace.  To safeguard against these different risks, consider mitigating them with DeFi insurance.

What Are the Returns?#

Returns for providing liquidity to a lending pool can vary dramatically. At the time of writing, some example rates include:

  • 1.77% on Ethereum at Aave
  • 1.57% on the Tether stablecoin at Compound
  • 1.38% on Dai at Aave

In some cases, centralized exchanges such as Coinbase or Nexo advertise higher returns than DeFi platforms. However, it's important to question where that revenue comes from, especially given the high-profile collapse of centralized platforms such as Celsius and FTX.

Before locking up any tokens in a centralized exchange, try to work out where the advertised returns are coming from. Is the company paying out in their own tokens or in a stablecoin? Are they paying returns based on loans being paid back or are they burning through seed capital and hoping to capitalize on the volatility of the cryptocurrency market? Some centralized exchanges offer interest-bearing options for people who lock up funds as a marketing tool so that the returns can be legitimate. It's always important to consider the counterparty risk before depositing, however. This is particularly true given that exchanges are not subject to the same regulations as banks.

The cryptocurrency bull run in 2020 and 2021 normalized the idea of returns of between 5% and 10% on cryptocurrency staking and liquidity provision, with platforms promoting such things as being "zero risk." These advertised returns are many times the returns available in the traditional finance market and proved unsustainable. It pays to be skeptical about centralized providers offering such returns and consider why DeFi platforms such as Aave and Compound are offering much lower rates than the centralized ones.

Even with DeFi platforms, there are some risks to consider. Before depositing, ask yourself the following questions:

  • What currency are the returns paid out in?
  • How long is the term of the loan?
  • Has the smart contract been audited?
  • Has the platform's website/app been audited?
  • Are you comfortable locking up your currency for the duration of the loan?

Overall, for savvy traders, using a portion of your cryptocurrency holdings to provide liquidity to a lending pool can be a way to put your currency to work. Depending on your investment horizon, you have the option of selling the returns or reinvesting them in the pool.

Become a Decentralized Insurance Underwriter#

At Neptune Mutual, you will find cover pools in our marketplace where the risks and returns are denominated in the USDC stablecoin. Those who purchase cover from one or more of these pools are insulated from the risk of smart contract hacks of prime DeFi applications. In addition, there are some options available for cover against custodial risk on exchanges such as Binance and OKX. Incident detection and payouts are automated, making the experience fast and reliable for investors. Neptune Mutual users have the option of purchasing cover or providing underwriting capital. Those who provide liquidity to the cover pools are rewarded for underwriting risk by receiving a significant portion of the policy fees, and importantly LPs have the option to withdraw their liquidity from the cover pool in a 7-day window that occurs every six months.