In the context of the layered structure of DEFI, a borrowing and lending protocol will consist of a number of Smart Contracts (the Protocol Layer) the function of which are simplified into a dApp/website (Application Layer).
The Protocol will be supported by one or more blockchains (Settlement Layers) charging fees to confirm DEFI transactions in new blocks of data.
The dApp/website will provide a User Interface for the Protocol Layer, listing rates of APY that can be earned by depositing (often termed supplying) different cryptocurrencies into Vaults.
If the user wants to start earning the interest they must simply ensure that they have funds available on the relevant blockchain and then connect their crypto wallet to the dApp approving the necessary permissions and fees. The layout will guide the users through the necessary actions.
As soon as funds have been committed they will start earning interest in that cryptocurrency which can be claimed at any time. In return, the Depositor will receive a token that acts as a receipt for the deposit they have made which is fully redeemable in proportion to the underlying asset as it grows with interest.
Depositing funds to a DEFI lending protocol also earns the user rewards in the Governance Token in proportion to the volume/length of deposits.
The Governance Token can itself be staked with the Protocol to earn a reward in return for providing a backstop against potential losses from hacks or black swan events.
Unless there are specific lock-up conditions the user can withdraw funds at any time just by paying the necessary network fees to the blockchain providing the settlement function.
How DEFI borrowing works
In traditional finance, there are generally two ways to borrow money – secured and unsecured loans. A secured loan requires an asset to be provided as collateral which will be sold if the borrower defaults on the loan. Property is a common form of collateral for secured loans.
Unsecured loans involve no collateral but require the borrower to prove their creditworthiness by supplying information about their financial circumstances.
Given that DEFI requires no personal information and happens at the Peer-to-Peer level with no outside authorities involved, unsecured borrowing is very complicated and beyond the average user (we discuss it below). The dominant form of borrowing from a DEFI protocol is secured via collateral in the form of another crypto.
The level of collateral required will vary depending on market conditions and the specific cryptocurrencies involved but the Loan to Value ratio will generally be around 60-65% and is calculated in fiat. This means that users must over collateralise loans generally borrowing up to 60-65% of the value of the collateral provided.
Given the volatility of cryptocurrency the value of the collateral can change, so that LTV figure will also change. If it falls below a predetermined level the user will get what is known as a Margin Call, a request to add more collateral.
If more collateral isn’t added and the LTV doesn’t recover then the user risks their loan being automatically liquidated with the collateral sold to cover the loan. A liquidation fee/penalty will also be taken from the collateral which will vary depending on the platform.
To take out a DEFI loan the user connects their crypto wallet to the dApp, selecting the required asset to borrow, agreeing to the APY for borrowing and required collateral, and then paying the required transaction and connection fees.
The collateral will itself earn interest (as above) which will be deducted from the interest paid on the loaned amount.
Unsecured DEFI Borrowing
As mentioned above secured or collateralised lending is the main form of borrowing within DEFI because of the difficulty of providing unsecured loans in a decentralised system. Decentralisation removes the layers of trusted intermediaries – like credit agencies – that require you to supply large amounts of personal information to prove your suitability for an unsecured loan.
Credit Delegation
One solution to unsecured DEFI lending is credit delegation; where a user with collateral can delegate it to someone with none.
Aave is one example of a DEFI protocol that offers credit delegation using Open Law, a system for creating legal agreements that work on Ethereum, to craft the necessary agreements.
Given the complexity of credit delegation, it isn’t targeted at retail users which is also true of the other more widely used form of unsecured DEFI borrowing – Flash Loans
Flash Loans
A flash loan is a way to borrow crypto funds from a lending pool without the need for collateral, provided the liquidity is returned within the space of one block confirmation of the settlement layer.
Flash Loans can fund complex chains of instant, programmed trades, looking to exploit arbitrage within the DEFI ecosystem – market inefficiencies across tokens and lending pools.
If the funds are not returned within one block, all the associated actions are reversed as if they never happened. If the funds are returned within the space of one block then the lending pool the funds were borrowed from doesn’t lose out – because the funds are returned and they pocked a fee of 0.09%. Whoever took out the Flash Loan gets to keep whatever value they were able to generate, net of the transaction costs associated with each step in the chain and the fee for the Flash Loan.
Given their complexity, most Flash Loans are written as Smart Contracts by developers with an intimate understanding of how DEFI Protocols work.
This might sound like dark financial arts, but it really is just applying the existing techniques that generate value within TradFi (investment banking and hedge funds), to the new world of DEFI (Decentralised Finance). However, given the decentralised nature of DEFI where code is law, Flash Loans have become a huge area of vulnerability.
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