Decentralized finance (DeFi) has seen tremendous development in recent months. Compared to the traditional finance industry, many people are already using lending platforms on a daily basis instead of using the cumbersome products of the traditional finance industry. According to DeFi Pulse, the ecosystem had a total value of about $20 billion in October 2020. This value increased to about 76 billion in February 2022. DeFi platforms seek to reshape traditional financial services in a decentralized and open way through blockchains, primarily Ethereum. Functions provided by decentralized protocols include exchanges, market making, and the traditional banking business of lending and borrowing. Since lending and borrowing liquidity are the most basic financial services, several decentralized solutions have been developed in recent years. – Authors: Tim Schmitz, Benjamin Schaub
Those who borrow money must trust that the money will be repaid. There are generally two ways in which the lender can ensure repayment of a loan [1]:
- Collateral: The borrower provides an asset, usually illiquid, that is kept under lock and key somewhere and serves as a guarantee that he will repay his loan.
- Verifiable identities: The borrower’s identity is known. If he fails to repay the loan, the lender may take legal action.
The traditional banking sector usually uses both methods to secure loans. Customers are verified, and if necessary, a collateral agreement is made, for example, a property that serves as security for the mortgage.
Lending and borrowing in DeFi
Compared to traditional finance, DeFi has no legal identification requirements (KYC/B); ergo, no reasonable legal claim can be made against lenders in the event of a breach of contract. Therefore, collateral is the only way for lenders to guarantee repayment of the loans they grant.
Collateral DeFi systems use smart contracts to lock tokens such as Ether. To account for the volatility of crypto assets, loans are typically overcollateralized, meaning the value of the collateral must be higher than the value of the loan. For example, if the required collateral is 150% of the loan, $150 in Ether is secured against a maximum of $100 in another coin, such as DAI.
Each DeFi lending platform has a way to ensure that enough collateral is locked over time. Assuming the loan is not over-collateralized by the specified ratio, e.g., because the price of the coin used as collateral drops, liquidation is forced to repay the lender. As an example of liquidation, let us consider a user who uses a platform with a required overcollateralization of 150%. He has deposited 170 USD in Ether as collateral and borrowed 100 USD in USDC. Suddenly, the Ether price drops, leaving his collateral with a value of only 140 USD. The missing collateral of his loan is discovered and the Ether tokens deposited as collateral are sold on the market to ensure the required over-collateralization ratio again.
Collateralized Debt Position
Currently, there are two systems of how DeFi lending platforms work. There are Collateralized Debt Positions and Collateralized Debt Markets [1]. Collateralized Debt Positions (CDPs) are a way to borrow money in a decentralized manner using collateral. The borrower locks assets in the form of token A as collateral in a smart contract and receives a loan in the form of token B. The loan is not provided by other users but consists of newly generated tokens from the platform. An example of a CDP is the Maker DAO, a decentralized, autonomous organization.
Maker DAO is one of the first and most popular DeFi platforms and one of the largest dApps on Ethereum. Maker DAO allows users to lock specific coins in smart contracts and then creates the crypto asset DAI [2]. DAI is a stablecoin; its price should not fluctuate and be worth one USD. Currently, DAI can be generated by locking, for example, ETH. Collateral must be at least 170% of the loan and include annual fees for a loan of 0.50% [3].
Collateralized Debt Market
While a CDP requires only one group of users to lock assets and receive the newly minted tokens, a CDM requires two groups of users: lenders and borrowers. Collateralized debt markets (CDMs) function more like traditional banks (see Figure 1). Some lenders provide liquidity and earn interest; the others are borrowers who receive liquidity and pay fees. As with CDPs, borrowers must post collateral to guarantee repayment of the loan.
Unlike CDPs, CDMs offer their users to borrow more different types of tokens. While users of Maker DAO can only borrow DAI, borrowers of platforms like Aave can choose between several tokens, including WBTC, LINK, UNI and BUSD.
Figure 1: Structure of a Collateralized Debt Market
Benefits of decentralized lending
Decentralized lending platforms share some common advantages in the DeFi space. Centralized systems require users to deposit their balances with the exchange, which requires them to relinquish control and trust the centralized institution. Decentralized platforms are trustless. Users do not have to trust any organization or give up control of their assets.
Technically, platforms consist of a series of smart contracts, usually running on Ethereum. The smart contracts and the transactions are immutable, and no one can take control of the platforms or exclude people from using the services. The platforms are open and can be used by anyone who is able to buy crypto assets. No bank account or KYC is required, and transactions are processed pseudonymously.
This currently raises some regulatory issues, as most financial service providers must follow strict anti-money laundering and counter-terrorism (AML/CT) regulations, which requires strict know-your-customer (KYC) processes. However, since DeFi services are mainly available to users who own cryptocurrencies, most of them have most likely already gone through a compliant identification process to buy the first tokens. Regardless of the huge market opportunities that exist in the DeFi space, many institutions prefer to wait for regulators’ approaches to a compliant framework to implement these solutions.
Conclusion
DeFi services have clear demand and offer obvious operational benefits to the traditional financial industry. The market is growing exponentially, and the tools used are very practical. Developers have created several decentralized credit and loan solutions in recent years. The loans are backed by the use of collateral. CDPs like Maker DAO allow users to lock assets and mint new tokens. CDMs like Aave and Compound provide platforms with liquidity pools for lenders and borrowers. When evaluating protocols, one should always keep in mind that DeFi is still a young industry and crypto assets are extremely volatile. It will be interesting to see what concepts take root next and whether lending platforms can find their way into the mainstream. While the pace of innovation at DeFi is very high, regulators need time to monitor developments and establish a secure legal framework. It remains to be seen how regulators will deal with decentralized financial platforms in the coming years.
Authors
Tim Schmitz is a working student at INTAS.tech and a B.Sc. student at the Frankfurt School of Finance & Management. His interests include various types of blockchain use cases, DeFi and data analytics. You can contact him via email (tim.schmitz@intas.tech) and via LinkedIn (https://www.linkedin.com/in/tim-schmitz-0893a81a9/).
Benjamin Schaub is a senior consultant at INTAS.tech. His interests include the development and integration of blockchain use cases in the financial industry as well as crypto custody. You can contact him via email (benjamin.schaub@intas.tech) and via LinkedIn (https://www.linkedin.com/in/benjamin-schaub/).
About INTAS.tech
INTAS.tech is a blockchain consulting company founded by Frankfurt School and Plutoneo Consulting, specifically tailored to the needs of financial companies. INTAS.tech focuses on the integration and management of digital assets, as well as the strategic assessment of blockchain deployment opportunities and their implementation.
Learn more about DeFi
If you want to learn more about decentralized finance, consider applying for the DeFi Talents Mentoring Program. This is an 18-week program designed to empower talent for leadership roles in decentralized finance. The program is run by the Frankfurt School Blockchain Center. For more information, visit the DeFi Talents website.
References
[1] Prof. Dr. Fabian Schär. (2021). Smart Contracts and Decentralized Finance. University of Basel – Center for Innovative Finance. https://cryptolectures.teachable.com/
[2] MakerDAO Whitepaper. https://makerdao.com/whitepaper/White%20Paper%20-The%20Maker%20Protocol_%20MakerDAO%E2%80%99s%20Multi-Collateral%20Dai%20(MCD)%20System-FINAL-%20021720.pdf
[3] Oasis Borrow (ETH-C). https://oasis.app/borrow (Retrieved 07 February 2021)
