DeFi Part 5: Decentralized Lending

At this point, you understand what decentralization is, why it’s important, many of the wonderful applications it offers, and where stablecoins fit into all of it.

As a result, you’re ready to delve deeper into the primary reason you started reading this series: capitalizing on the many opportunities this space has to offer.

With this article, the Intro to DeFi series will steer towards covering practical ways for you to make your money work for you in the world of decentralized finance. And to start off, we’ll look at a passive source of revenue that anyone can quickly grasp: lending.

Table of Contents

  • How Decentralized Lending Works
  • Understanding the ROI on Decentralized Lending
  • The Risks of Decentralized Lending
    • Cryptocurrency Volatility
    • Security Hacks
  • Is Lending a Good Way to Invest in DeFi?
  • Key Takeaways

How Decentralized Lending Works

In the traditional finance world, an entire host of parties are involved to facilitate lending and borrowing. From banks and their agents to third-party collectors and many other third parties, the entire process is riddled with legal complications and trust issues.

Decentralized lending can cut out all those middlemen by automating the entire process through smart contracts. But how can the system ensure repayment of loans? It’s done by offering over-collateralized loans only.

For instance, if you want to borrow $1,000 worth of Bitcoin by putting your Ether tokens as collateral, you’ll typically have to deposit $1,250 worth of Ether tokens. Since the price of these assets fluctuates by the second, the platform will monitor your collateral in real-time.

If the worth of your collateral falls below $1,050 (roughly speaking), the platform will automatically liquidate your assets and immediately take its original capital back. Since all these operations are fully automated by code, there’s virtually no room left for fraud.

As is the case with traditional banking, lending protocols charge borrowers interest on their loans, which is calculated by the hour in many cases. Since these protocols are decentralized and automated, they pass the vast majority of revenue from interest payments off to the lending users.

Understanding the ROI on Lending

Banks are notoriously bad when it comes to earning passive returns on your savings. Even the best savings accounts typically fall short of a 3% annual return. When you consider the expected inflation of 7% these days, it becomes obvious that you’d be losing money every year.

However, decentralized lending protocols can generate surprisingly high yields for lenders owing to the efficiency of their operations among other factors.

Even if you use a stablecoin like USDT (pegged to U.S. dollar) and lend to the popular BlockFi protocol, you’ll net 9.25% per year in interest on your capital. This is based on today’s rates, however, which are always subject to change as market dynamics shift.

It’s worth noting that these are relatively low-risk investments. That’s because stablecoins are resistant to the volatility of the broader crypto market, as these assets are pegged to the U.S. dollar in most cases.

The Risks of Decentralized Lending Protocols

Even though lending protocols automate everything and take a significant amount of risk off the table, there’s always some risk involved.

Let’s look at some of the risk factors that you must consider before parking your capital into one of these applications.

1. Cryptocurrency Volatility

If you use a popular cryptocurrency like bitcoin or ether for lending, then you’ll be exposed to its volatility. This could be both a good or a bad thing, depending on which way the market swings. But the key point to remember is that the asset you loan others is exactly the asset you’ll get back.

For instance, if you loan one whole bitcoin at a price of $42,000, and the price plummets to $32,000 during the course of the loan, you won’t get your full capital back. Your capital will be worth $32,000 plus whatever interest you earned on it. The inverse is true as well. If the price of bitcoin jumps to $60,000, then your capital will be worth that much plus interest.

As we highlighted earlier, however, you can use stablecoins for lending. Doing so will automatically mitigate volatility risks.

2. Security Hacks

Whenever software is brought into the picture, security hacks follow. It’s inevitable and unavoidable reality of technology. As such, there’s always the possibility for a flash loan attack or a smart contract bug or just a general platform exploit that could drain your account of all its assets.

Is Lending a Good Way to Invest in DeFi?

On one hand, you can beat the interest rates paid by banks and even index funds. The risk profile of lending stablecoins is surprisingly safe. However, this limited risk profile comes with a limited upside too, as other methods of DeFi investing can yield far more attractive returns.

Nonetheless, lending remains one of the most popular investment options in this space. Our recommendation is to investigate the other ways of generating returns in DeFi, which we’ll cover over the next few articles in this series. You’ll be in a much better position to make an educated decision then.

Key Takeaways

  • Decentralized lending is like traditional lending, but without any trust issues or middlemen involved.
  • These protocols can generate almost double-digit returns while sidestepping the volatility of cryptocurrencies by using stablecoins
  • However, security issues are a valid concern. There have been many instances where hackers managed to drain 9-figure or even bigger protocols.

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