Decentralized Finance is a burgeoning niche under crypto industry. Within a short span of 12 months, the industry size grew from $20B locked in value to $250B. This validates the hypotheses that crypto is here to stay. Not only that, it also proves that Decentralized Finance is going to play an important role in the crypto adoption. Decentralized finance has a lot of use cases which have the capability of transforming our traditional finance. However, in this post, we are going to talk about what borrowing and lending in DeFi.
Borrowing and lending are backbones of any thriving economy. It is a pillar used by governments to control the prices and inflation. For instance, if a government wants to control the inflation, they make it expensive to borrow money. Similarly, if they want to add fuel to the economy, interest rates are made cheaper. This means more people would borrow and spend. Thus, driving up the prices.
Why Decentralized (DeFi) Borrowing and Lending?
At this point you may ask, why do we need to have decentralized borrowing and lending? What are the issues with the current banking system? And it is indeed a legit question. The banks across the globe have done a decent job in managing this portfolio for all of us. Then why is there is sudden urge to do away with them now?
Let us explore some legit reasons behind exploring DeFi avenues:
A. Unequal Access:
While banks try their best to lend money to most of the people that knock their doors, they often have to comply with certain norms and regulations to ensure that their loan books are not filled with defaulters. Essentially, banks are in the business of loaning out your money at a certain percentage. However, if more and more people fail to give back that money, it is detrimental to their cause.
This means not all of us can have access to same amount of loans. As you all might know that there is a credit score assigned to each individual. That score decides if or not we should be lent money and at what interest rates. This clearly creates a divide in the market where rich keeps on getting richer and vice-versa. It takes a while for someone from middle class to build assets.
B. Access Restriction:
Let us take this up by talking about recent situation in Ukraine. A lot of individuals fled to nearby countries like Poland to safeguard themselves. These innocent citizens cannot access their banks back at home. On the top of it, these citizens cannot open bank accounts in the new country. Even if they do, it is going to be a long road before someone is willing to lend them money.
Therefore, there is a clear lack of access to lending services for these people despite having money and a credit history.
C. Trust Based Relationship:
We trust banks completely to keep our money safe and give it back to us if need be. This equation works well in an ideal world but the real world scenarios are quite different.
This trust makes banks an extremely powerful entity that it gives rise to frauds if not handled carefully. For example, Indian business tycoon Nirav Modi bribed certain employees in one of the Indian banks to access collateral free loans. Later, he defaulted on these loans and who took the brunt? Yes, it is the unknowing tax payers of the country.
This means while trust is an extremely important element of this relationship, more often than not, it is compromised.
To process these transactions related to borrowing and lending, banks also charge its customers a fee. This is obviously on the top of the interest rates they are going to levy. Nonetheless, who decides on this fee? Banks take a note of their customer satisfaction scores, add some value to ease out the process and finally come up with this fee themselves.
But do you think it is fair? Even if there is a fee involved, the prices should be governed by community. This would ensure that banks do not play the role of an opportunist.
E. KYC and Other Processes:
When was the last time you took a loan from the bank? Depending on the type of the loan, it could take anywhere between 10 days to a month. There is an elaborate process that can take forever for you to get the money in the bank.
Therefore, you can question the efficacy of the process.
F. Banks have the Final Authority
Banks conduct a thorough due diligence before lending you the money. And it is absolutely fine to do so. But banks have standardized this process over the years. This means if you are planning to do anything unconventional, it would be difficult for the banks to fund your business.
For example, if you are building a crypto startup in a country where regulations around crypto are not clear, most of the banks will not fund your business.
Globally, 1.3bn people do not have the access to the banks. However, about 60% of these people have access to a smart phone and internet. The question here is that these people do not have access to capital because they are not registered with a bank.
What is Borrowing and Lending in DeFi?
Now that we have established the need for DeFi in borrowing and lending. Let us understand what it is and how does it work. These basic banking functions happen via protocols like Compound and Aave. Maintaining the ethos of the Blockchain, these protocols are completely decentralized in nature. By eliminating the middle man, one can surpass the following problems:
- Banking the unbanked
- Accessible to everyone with collateral
- No KYC required
- Cheap (no middleman involved)
How does Borrowing and Lending in DeFi Work?
Lending and borrowing in fact a huge part of our current financial system. Why this works seamlessly is because banks usually ask you to put something like collateral on the line. If you default on your loan, banks liquidate that collateral to recoup the money. There could be other legal consequences involved too if you fail to pay back. All this is possible because there is a whole set of documents and KYC involved before disbursing the loan.
How do you deal with the problem of defaulters in cryptoverse? There is no KYC. Anyone could make a small down payment and run away with the loaned amount.
The answer lies in overcollateralization and smart contracts. For borrowing fiat money worth $1000 you may have to put $1200 worth of cryptocurrency as collateral. One may ask why would I borrow if I already have the money? Well, say you hold BTC worth $1000 and you strongly believe that it is going to jump higher in the coming days. In such a case, you would not sell your holdings and instead borrow money using that crypto. You can use that money to trade elsewhere and make some money, only to come back and repay your loan.
Well, once again, smart contracts are to the rescue. Say you have additional crypto lying around and you want to earn interest on it. So you go to a crypto lending platform like AAVE or Compound and deposit your crypto worth $10,000 in a smart contract. In return you get a different token (Lets call it X token) which is a representation of your crypto along with some pre decided interest.
Comes along another person who needs a loan of 10,000. He can put another crypto as a collateral (>10,000 worth) into that smart contract and now if he tries to run away with that money, smart contract will automatically liquidate his holdings and pay you back.
Gateway from Web2 to Web3: EPNS
So you understand what is borrowing and lending in crypto. You also know that loans are overcollateralized so that you are liquidated if your collateral loses a certain value. Problem is that crypto markets are running 24x7x365. What happens if you are liquidated at a point where you aren’t paying attention.
Unless you are a full time trader, it is very difficult to stay hooked and track your borrowed money and collateral. Which is why folks at Ethereum Push Notification System or EPNS have come up with a product that sends you notifications from a decentralized world.
Currently all notifications are centralized and sent to you via Apple or Android servers. But there is no such thing in DeFi. You are connected to a dApp instead. So EPNS takes charge of sending notifications by these protocols to you.
And guess what, unlike Apple and Google, this is consensual. You need to opt in for receiving notifications. Or else, you get paid to receive one from a protocol you haven’t opted for. Smart right?
Let us do this!
Eager to give this a shot? Well, not so soon. You need to understand the nuances of Cryptocurrency and Blockchain. And for kickstarting that journey, you need to take certain courses to prepare yourself for this upcoming revolution.
A good starting point to unveil the magic behind cryptocurrencies is to go step by step from Blockchain, crypto to NFTs. Here is a complete catalogue to get started.