What is DeFi Lending and How Does it Work?

DeFi, or Decentralized Finance, is a collection of financial applications that are built on blockchain technology. These applications don’t have any third-party or central organization that controls the flow of transactions. In other words, DeFi incorporates a peer-to-peer or person-to-person network that lets anyone manage their assets securely and transparently. As DeFi is growing in popularity, so is DeFi lending.

What is DeFi lending?

In the simplest terms, DeFi lending platforms offer crypto loans in a trustless way where there won’t be any middle parties involved. DeFi lending allows users to make their crypto coins available on the platforms for lending purposes.

The DeFi lending model works where a borrower can directly take a loan by using the DeFi lending platform, often referred to as "P2P Lending". Here’s what the simplified process looks like:

  • The lenders enlist their crypto coins on the platform
  • The borrower directly takes a loan using the P2P lending platform
  • The lender earns interest after getting his loan returned.

When we compare all the decentralized apps or DApps, we can see that DeFi has the highest growth and it has become quite essential in the crypto world. Now, let’s go a bit deep into how DeFi loans work.

How does DeFi lending work?

As we all know, the value of crypto assets increases or decreases with time. However, your cryptocurrencies sitting idle in your wallets won’t do anything. You wouldn’t be able to earn any money. The assets will only go up and down with time, and you won’t even be able to earn any interest this way. However, the DeFi loan allows a win-win situation for both the lender and borrower. It allows the lender’s crypto to be lent to someone else, and in this way, the lender can earn some interest.

In traditional transactions, only banks or financial institutions are lenders. However, thanks to DeFi, anyone can become a lender or borrower without a middle party. By lending their crypto assets, people can now earn interest directly without involving banks.

The process is done using “Lending Pools”.

Lending Pools

By using smart contracts, users can pool their assets on the blockchain and later provide them to borrowers. There are a plethora of ways to charge for interest using DeFi. In other words, each pool usually has a different approach to how to borrow, and the interest rates vary as well.

But you must be wondering, “What about collateral?” Let me explain. In traditional banks, when you take a loan, you usually provide them with some sort of valuable assets, like a car, house, or more. However, with blockchain, since there’s no mid-party involved and the assets aren’t physical, what can you provide?

Collaterals come in different varieties in DeFi. So, from any crypto token that can be used to exchange the borrowed currency for something more valuable than the loan amount on the blockchain, you will need to at least provide something like that. Let's say that you want to borrow one bitcoin. In order to loan it, you will need to deposit the price of one bitcoin. This is the type of security you will be expected to have. Well, that’s about it. This is how DeFi lending works. Now, let’s talk about the potential upsides and downsides of borrowing or lending.

But Why Take a DeFi Loan?

You might be thinking why someone would take a DeFi loan considering they could just sell their assets directly! Here are some top reasons why DeFi loans help:

You get funds quickly

DeFi loans enable you to get loans quite easily and quickly if you have a lot of cryptocurrencies. There are many companies that are providing crypto-backed loans that can be vital, especially in case of an emergency. So this way, you wouldn’t need to sacrifice your own cryptocurrencies and you could just get funds from the lender and then return it to them according to the agreement.

It benefits when the crypto price goes up

Suppose that there’s a signal about Bitcoin price going up. So, you deposit $5,000 worth of BTC into a DeFi protocol. After that, you take out a $2,500 loan in a stablecoin that has the lowest rate, like Tether. In that case, you will be locking the price of BTC at a lower price. And once the price of Bitcoin actually goes up, you can easily give the loan back and earn the difference. This way, you will get paid interest on the $5,000 that you deposited.

Liquidity mining

Whenever you deposit assets for liquidity mining, you get a bonus interest to lend and borrow from various DEXs. You not only get the interest on your deposit but also the bonus interest paid to take out the loan. This way, liquidity mining has become a great way to earn bonuses while making it easier for people to lend and borrow loans.

Final Verdict

DeFi lending is an excellent way for a crypto holder to get a loan since it’s easy, transparent, and secure. The main benefit is the decentralization of current financial services like investments, lending, borrowing, trading, payments, insurance, and a lot more.

While DeFi has been here for quite some time, it is still developing and improving rapidly and is fast reshaping the way we look at financial transactions.