DeFi lending and borrowing: A guide to earning passive income
By Gaurav Arora
Lending and borrowing, which have been integral to the world of finance since ancient times, predate even the barter system and the concept of payments. In traditional finance, lending involves providing a loan to a borrower who repays it with interest within a specified timeframe. Collateral is often held by the lender to reduce the risk of default. However, with technological advancements, these services have been incorporated into digital platforms. This integration is driven by consumers’ increasing demand for streamlined processes and faster approvals.
In this context, decentralized finance (DeFi), powered by blockchain technology, has emerged as a novel solution, fundamentally transforming the lending and borrowing landscape.
What makes DeFi Lending different from Traditional Lending?
The decentralized world of blockchain uses smart contracts to facilitate lending and borrowing without the need for intermediaries. Smart contracts play a crucial role in revolutionizing lending and borrowing in the decentralized realm of blockchain. Traditional lending faces a significant challenge in collections, where lenders struggle to recover funds and collateral may not suffice to cover loans. However, smart contracts address this issue with the help of rules enforced by embedded logic. By automating processes and eliminating intermediaries, smart contracts streamline lending, ensuring repayment and mitigating default risks.
Selecting an App or Wallet
When entering the realm of DeFi, choosing the right app or wallet becomes paramount. A well-rounded app or wallet, preferably self-custodial to ensure safety of fund, should offer essential elements such as robust security measures, compatibility with multiple chains and protocols, and a user-friendly interface. These features not only safeguard your assets but also facilitate seamless navigation and interaction within the DeFi ecosystem.
Users often encounter challenges when exploring DeFi, including the daunting task of identifying the right opportunities while understanding and managing associated risks. The complexity of juggling multiple wallets and self-managing private keys can also prove cumbersome and inconvenient. To overcome these challenges, selecting a wallet that addresses these pain points is crucial. Look for options that provide earning opportunities through trading various tokens and accessing high-yield generating pools. A user-friendly interface and keyless access can simplify the DeFi experience by streamlining navigation and eliminating the need for intricate key management. With advanced security measures based on Multi-Party Computation (MPC) technology, these wallets ensure robust protection and grant users complete control over their assets.
Why Lend Your Crypto Assets?
DeFi loans serve as a crucial solution for crypto holders who want to earn interest on their assets instead of simply holding them in wallets. Unlike traditional banking, where banks exclusively offer lending services, DeFi opens up the opportunity for anyone to become a lender and earn interest on their lent-out crypto assets. This aligns with the concept of HODL (Hold On for Dear Life) in the crypto community, as individuals can hold their assets while simultaneously earning passive income through lending. Additionally, borrowing against your assets can be advantageous for various reasons, such as accessing liquidity without selling your crypto holdings, leveraging investment opportunities, or managing short-term financial needs while still maintaining long-term asset ownership.
Opportunities available in the DeFi ecosystem
There are many mechanisms by which lending protocols generate passive yield and each one of them have different nuances and risks. The simplest is to simply loan an asset to another user, similar to how it works in other asset classes like equity. Staking is another way to earn income for native tokens of chain where the deposited tokens are used to validate transactions. Lastly liquidity pools and yield farming are more complex mechanisms of earning possibly higher income but come with specific risks.
Another way to earn passive income through DeFi is by borrowing a token from a platform that can be used to earn rewards on the same or any other platform. For example, a user can deposit a portion of BTC, let’s say $2,000 worth, on a DeFi platform in exchange for wBTC, earning an APY depending on the rewards at that time. Although this may seem like a small return, it provides the opportunity to take a decentralized loan for another coin that may offer a higher return. This allows users to earn passive income while benefiting from the capital growth of the original asset and the interest earned.
Collateral in DeFi Lending
When borrowing from a bank, a collateral is required to secure the loan. For instance, if a person takes out a car loan, the car itself serves as collateral, and the bank will repossess it if the borrower fails to make payments. In a decentralized system, collateral is still necessary, but it doesn’t involve any physical property, and the process is anonymous.
Decentralised loans are often over collateralized, that means, the borrower must offer something of value that exceeds the amount of the loan. Smart contracts are utilized to deposit an amount of cryptocurrency equal to or greater than the loan amount. Various types of collateral are available, and any crypto token can be exchanged for borrowed cryptos. For example, if someone wants to borrow one bitcoin, they must deposit the equivalent value of one bitcoin in DAI.
Conclusion
The resilience of decentralized lending protocols became evident during the Celsius bankruptcy incident in 2022, as they swiftly prioritized repaying loans from decentralized platforms while defaulting on loans to centralized entities. This demonstrated the robustness and trustworthiness of decentralized lending systems, which prioritize transparency, immutability, and user empowerment. The incident highlighted the inherent advantages of decentralized finance (DeFi) in providing a more secure and reliable lending environment, where borrowers and lenders can have greater confidence in the integrity of the system.
These concepts will become even more powerful when attached to real world assets. For example it is quite possible in the future that one could get instant loans by using their digitized house deed as collateral for short periods to tide over tough cashflows.
The author is head, DeFi initiatives, CoinDCX
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