Jul 3, 2023 12 min read

DeFi Education #3: DeFi Lending & Borrowing

Session #3: DeFi Lending & Borrowing

Presented by Joe_King [22 September 2022]

Summary, organization and additional detail by DigitalSoul.x

This presentation is an introduction to decentralized finance (DeFi) lending and borrowing. After a brief discussion about foundational concepts, three different DeFi platforms will be presented along with a short demonstration of their use. These platforms are AAVE, Maker DAO and Alchemix, each of which offers a unique approach to lending and borrowing.

Introduction to DeFi Lending and Borrowing

Lending and borrowing are the foundational components of all financial markets. By lending assets, financial resources are offered to those in need, such as businesses, entrepreneurs, and individuals. Borrowers can then put these assets to work by starting businesses, financing projects, or utilizing the funds for personal obligations or investments. This process enables capital to flow from savers and investors to those who need it, promoting economic growth and development.

In traditional financial (TradFi) markets, you offer your money to a bank and they pay you a minimal interest rate. In many cases you have the freedom to withdraw your capital whenever you like. Borrowers can then borrow those funds from the bank by agreeing to pay it back with interest later. Borrowers can use the capital to pay for things like university fees, car loans, and mortgages, while the lending vehicles include certificates of deposit, treasury bills, and repos. Consider a product like a mortgage: a borrower takes out a 30-year loan at 4.5% interest, while the bank pays only 0.1% interest to depositors. The difference between these two rates is called the spread, which is how banks make money. They use your money, pay you interest, lend your funds out to others, and receive more interest from those borrowers.

In the DeFi realm there are still lenders and borrowers, but instead of going through a bank, DeFi uses code and smart contracts. The protocol passively pays you interest which can range from 2% to 20%, depending on the protocol. On the borrowing side, there are some significant differences to traditional markets. Since there are no credit scores in crypto yet, and no way to do under-collateralized loans, you have to deposit more money than you’re borrowing. For example, if you have crypto tokens and put $100 worth into a protocol, you might only be able to take out $60 against your loan. These are called collateralization ratios, and they vary depending on the protocol and the asset you’re using as collateral. The collateralization ratio depends on the asset you’re posting and the protocol’s parameters, which are set by the protocols to protect themselves. This is one of the most critical aspects that sets DeFi apart from traditional finance.

Over-collateralization

People may wonder why they would want to put $100 into a protocol just to borrow $50 or $60. There are several reasons for this that we will explore further:

1) Short Term Liquidity — Someone may think that the value of the IOTA token will increase by 5x in the next two years, but they might need cash now to pay their bills or deal with an emergency. In this case, they can post their IOTA tokens as collateral, borrow money against it, and still own the underlying tokens. As the value of the tokens increases, so does the value of their investment. So, the person can remain exposed to the underlying asset and still enjoy the price appreciation while covering their short term liabilities.

2) Tax Protection — In the US for example, short-term capital gains taxes are 22%, so borrowing money against collateral may be cheaper than selling the assets. This strategy is commonly used by the ultra-wealthy who borrow against their collateral assets such as stocks and houses to fund their daily expenses.

3) Diversification — A person could borrow against their long-term holdings to buy something in the more short-term. They can then sell that asset, repay the loan, and have more assets across the board. For instance, suppose you see a short-term opportunity in the market. Rather than selling some of your long-term holdings to participate, you could borrow against your position to take advantage of the opportunity in the short-term.

4) Arbitrage Yield — For the sake of argument, let’s assume that you could borrow stablecoins on one platform at 1% interest and lend them on another platform that pays 4% interest. In this case, you net 3% on your assets as a short-term investment.

5) The “degenerate play” — In this situation, a person can use leverage to invest in more and more tokens. They borrow against their primary holdings, buy more tokens, lock up more tokens, and borrow more until they have no money left to borrow, essentially leveraging their assets up to 9–10x.

There are efforts underway to find alternatives to over-collateralization in DeFi. Some DeFi projects are exploring under-collateralized lending, while others are developing on-chain credit scores to determine the creditworthiness of borrowers. Another solution is social consensus, where borrowing and lending pools only let vetted members invite others into the pool.

Benefits of DeFi Lending & Borrowing

● Automated Processes — DeFi lending platforms use smart contracts to automate the lending and borrowing process. These contracts handle the transfer of assets, calculate interest, and manage collateral. This automation eliminates the need for intermediaries like banks, reducing costs and enabling permissionless access to financial services.

● Decentralization — Traditional financial markets rely on centralized intermediaries such as banks, lending institutions, and clearinghouses. DeFi lending, on the other hand, operates in a decentralized manner, leveraging blockchain technology and smart contracts. It allows direct peer-to-peer lending and borrowing without the need for intermediaries.

● Access and Inclusion — DeFi lending platforms are open at all hours and they are permissionless. Anyone with an internet connection and a digital wallet can participate, regardless of their location or background. This provides greater financial inclusion and access to financial services for individuals who may not have access to traditional banking.

● Transparency — DeFi lending platforms are built on public blockchains, making the transactions and smart contract code transparent and auditable. This level of transparency provides users with visibility into the platform’s operations and enhances trust in the ecosystem.

● Programmability — Smart contracts enable programmability in DeFi lending. Users can create complex financial arrangements, automate interest calculations, and execute various actions based on predefined conditions. This flexibility allows for innovative financial products and services that can be customized to individual needs.

Disadvantages of DeFi Lending & Borrowing

● Hacks — DeFi protocols have their share of risks, and one of the most significant is the risk of hacking due to the fact that it involves code. Lending and borrowing protocols have been frequent targets of hacks, leading to the loss of funds. To compensate for the risks, DeFi protocols tend to pay higher interest rates.

● Over-collateralization — Additionally, the protocols tend to be over-collateralized, making it difficult for people without substantial capital to access loans. Small business owners are typically strapped for cash, and it wouldn’t make sense for them to enter into an over-collateralized loan. Similarly, a person in the market to buy a home wouldn’t want to offer twice the value of the home as collateral. There are just a couple of cases in which DeFi borrowing doesn’t make sense with the products currently available.

● Variable Rates — Borrowing rates are usually variable and subject to change based on an algorithm that depends on the utilization of the pool. Due to the volatility in crypto, the rates can change quickly. And, since the market is always open, you could get liquidated overnight is the market is particularly volatile.

● Fees — Also, there are still fees involved with these protocols, so we can’t escape this feature of the traditional lending market. Most DeFi protocols also charge a stability fee, which is similar to a loan origination fee in traditional finance. Unfortunately some of the relics of TradFi have been incorporated into DeFi as well.

● Regulation — DeFi operates in a relatively unregulated space, which can provide more freedom but also presents challenges in terms of investor protection and regulatory compliance.

Oracles

DeFi protocols use price oracles to get the market price of assets. These oracles provide the protocols with the prices they need to execute transactions. Chainlink is the leading price oracle used by most DeFi protocols, but Maker DAO, for instance, uses multiple streams of price oracles to ensure the accuracy of the prices. This is important, because if there was a problem with Chainlink and the price of Ether was reported to be half of it current value all of a sudden, many borrowers would get liquidated. So, as you can see price oracles are extremely important and it is recommended that you familiarize yourself with the oracles used by the platforms you are considering to ensure that they’re using more than one reputable source.

Now that we have discussed the process of DeFi lending and borrowing and listed the pros and cons when compared to TradFi, we can explore several different platforms to see how they work and to learn about their unique features.

AAVE (https://aave.com)

AAVE is a simple money market fund and is considered one of the most trusted DeFi primitives. It was created in 2017 as a product protocol called Etherlend, and after numerous iterations, mistakes and problems they rebranded to AAVE in 2020. AAVE is the Finnish word for ‘ghost,’ meaning that the platform is transparent but also anonymous. Large investors, such as Mark Cuban and A16Z, have invested in this platform. AAVE operates on multiple networks including Ethereum, Avalanche, Optimism, Polygon, Arbitrum, AAVE Arc, and more.

Users can supply or borrow assets on these networks, and when users choose to borrow they have the option of choosing variable or fixed rates. Interest rates will vary depending on the network and the type of asset being supplied or borrowed, but there is no fixed date to return the capital. The variable loan rates are calculated algorithmically based on the demand for a certain asset, and can change over time. The stable rate can give you peace of mind knowing that your interest rate will never increase, while the variable rate can potentially give you a lower rate upfront but carries the risk that it will increase over time.

AAVE Demonstration:

Maker DAO (https://makerdao.com/en/)

Now we consider the first DeFi protocol created: Maker DAO. It was originally theorized 2014 and actually put into practice in 2017. They are the issuers of DAI — an over-collateralized stable coin, as well as the inventors of their multi-collateral DAI vaults. If you’ve been in the crypto space for a significant amount of time, you’ve probably used or at least heard of DAI.

Maker DAO is a decentralized autonomous organization (DAO) built on Ethereum that allows users to create and manage the DAI stablecoin. Unlike centralized stablecoins like USDT or USDC, DAI is over-collateralized, meaning that users need to put up more collateral than the value of the DAI they want to create. Maker DAO’s system is designed to maintain the value of DAI at $1, and users can borrow DAI against their collateral at a certain collateralization ratio.

Maker DAO’s assets are approved by Maker governance, and the platform allows for a wide variety of collateral types, including ETH, Bitcoin, Link, Uni, and others. Users deposit their chosen collateral into a digital vault and borrow DAI against it. Unlike Aave, where there are lenders on the other side, Maker DAO is the lender and creates DAI by printing it.

One of the main goals of Maker is to become the backbone of many lending protocols. Various platforms, including Oasis Finance, use Maker as their backend. Maker DAO has two tokens: the governance token, MKR, and the stablecoin, DAI.

If you need liquidity, you can enter into an over-collateralized loan by borrowing against your deposited assets, such as ETH. You can withdraw the borrowed DAI into your bank account to pay your bills, or use it to buy other assets or engage in arbitrage. Depositing DAI into other lending or borrowing platforms can earn you a return of around five to six percent. Maker DAO charges fees, which are used to pay for its operating expenses, including the payroll for various core units that operate inside the platform, such as handling price Oracle feeds, governance, and delegates.

Regarding liquidations, if a user’s collateral falls below a certain threshold, Maker DAO will automatically liquidate their collateral to cover the debt by utilizing a third party actor called a keeper. For example, if a user has $300 in collateral and borrowed $185 worth of DAI, and the stability fee and liquidation threshold are set at $5, then if the value of their collateral drops below $190, Maker DAO will offer the collateral to keepers who bid on the assets. The winning keeper uses their funds to cover the debt. The user will keep their DAI, and the keeper gets the collateral at a slightly lower price than market value to profit on the spread. Most keepers are bots these days.

One interesting thing about Maker is their approach to governance. Maker governance is decentralized and anyone can participate in it by holding MKR tokens. The governance process is known as “maker improvement proposals” (MIPs) and anyone can submit a MIP. The community then votes on the proposal and if it receives enough support, it can be implemented into the system. This decentralized governance model is one of the key features of Maker and allows for a more democratic approach to decision-making.

Another important aspect of Maker is its stability fee. This is a fee that is charged on outstanding DAI loans and is intended to help maintain the peg to the US dollar. The stability fee is set by Maker governance and is adjusted based on market conditions. If the DAI price is trading above $1, the stability fee is increased, while if the DAI price is trading below $1, the stability fee is decreased. This system helps to ensure that DAI remains stable and maintains its peg to the US dollar.

In terms of adoption, Maker has been very successful in the DeFi space. DAI is one of the most widely used stablecoins in DeFi and is used as collateral in many different lending and borrowing protocols. Maker has also been adopted as the backend for many other DeFi protocols, further increasing its reach and influence in the ecosystem.

Overall, Maker is an important player in the DeFi space and its over-collateralized stablecoin DAI has played a key role in the growth and adoption of decentralized finance. With its decentralized governance model and commitment to maintaining a stable peg to the US dollar, Maker is likely to remain a significant force in the DeFi ecosystem for years to come.

Maker DAO Demonstration:

Alchemix (https://alchemix.fi/)

The last platform to be discussed is Alchemix: a DeFi lending and borrowing platform known for introducing self-repaying loans and synthetic tokens. Similar to Maker, Alchemix operates as an over-collateralized borrowing platform and lending protocol. It offers vaults and farms as different yield strategies to generate interest on deposited assets. Unlike traditional loans where borrowers pay interest and have a fixed repayment date, Alchemix’s self-repaying loans pay borrowers interest and have no fixed repayment date. The interest is paid through a yield strategy deployed on the deposited assets.

The amount that can be borrowed at any given time, known as the debt ceilings, fluctuates based on the utilization ratio and the available collateral. Alchemix has various strategies that offer different interest rates for different crypto assets. When borrowers deposit assets into a yield strategy paying, for example, a two percent interest rate, they can borrow up to 50% of the deposited asset’s value. However, the interest repayment only occurs on the portion of the deposit that remains in the vault, not on the borrowed amount. This means that if a borrower deposited $100 and borrowed $50, they would only receive interest on $50 of their deposit. With interest at one percent, it would take approximately 100 years to repay the loan if half of the deposit was borrowed (not considering compounding for simplicity). However, it’s worth noting that the purpose of self-repaying loans on Alchemix is not necessarily to fully repay the loan but to generate yield on the deposited assets while maintaining exposure to the borrowed funds.

One notable feature of Alchemix is the ability to withdraw funds once the interest on the loan has repaid itself or manually repay the debt. Unlike Maker DAO, borrowers have the option to self-liquidate their loans. By pressing a button, the system will sell the borrower’s collateral equivalent to the borrowed amount, allowing them to close the loan and retrieve their collateral.

Alchemix also utilizes synthetic assets, which are tokenized derivatives. For example, Alchemix takes ETH and issues an Al-ETH token that represents the locked ETH within the platform. This token allows borrowers to trade and borrow against its value, knowing that it can always be swapped back to regular ETH. Synthetic assets provide a transparent way to track assets within the system and facilitate borrowing and trading.

In traditional financial markets, derivatives can be complex and pose risks to the global financial system. There are actually many different types of derivatives and they’re extremely complicated if you’re not familiar with them. However, in the blockchain space, derivatives are transparent, enabling better oversight and safety. The transparency allows users to monitor the issuance and movement of derivatives, mitigating concerns about potential risks to the financial system.

Alchemix.fi Demonstration:

In conclusion, despite the few notable risks associated with DeFi lending and borrowing, there are still plenty of reasons to engage in these financial markets. DeFi lending and borrowing is permissionless, available to everyone, and promotes equality. There are no biases towards genders, races, or religions; as long as someone has the funds, they can borrow. It is also fast, with loans being done at block speed, and available 24/7. Additionally, it is transparent, and people can see who is borrowing and what protocols have leverage. Lastly, DeFi can also be tax advantageous, as borrowing money may be cheaper than selling assets. New innovations are being tested daily, so the DeFi options for lending and borrowing may soon surpass other traditional options.