DeFi and the future of the global economy: Lending Platforms
This blog post is be split up into four sections:
Part 4: Lending Platforms
We’re now at our third and (for now) final application of Decentralized Finance: peer to peer lending, one of the fastest-growing and most exciting areas of DeFi.
Lending has traditionally been monopolized by banks and financial institutions. It involves credit scores, personability, and trusting big financial institutions that need to earn a profit on top of what is needed for a transaction. One of the initial aims of blockchain technologies was to be able to cut out the middle man: banks and financial institutions that control the financial ecosystem. As seen recently with the GME uprising, banks and financial institutions aren’t in high favor now.
One big issue people have with banks is credit systems. Say you want to get a loan, a bank will usually look at your credit score in order to decide your interest rate or if you’ll even get a loan in the first place. While on the surface this is a system intended to mitigate risk to banks, many have criticized the system for having racial bias, as well as being hard to build, especially for younger populations and immigrants with little to no financial history.
In comes distributed trust! With a distributed financial system, we can go around banks and create a peer-to-peer lending network whose rules are public and transparent, allowing those with lower credit scores or those with lack of access to the financial infrastructure needed to get a loan, to be able to borrow money from others seeking to make some extra income by lending it out.
Over-Collateralized Lending
The lending subspace of DeFi is only just getting off the ground. Most lending platforms require you to be over-collateralized, meaning that you can only borrow as much as you tie up in the smart contract. This means we don’t need credit scores because non-payment leads to the protocol liquidate the funds tied up by that user (plus a bit more). For example, if I put up $100 in ETH as collateral in the Compound protocol and ETH’s collateral factor is 0.75, that means I can borrow up to $75 in ETH from the protocol. If I don’t pay back my loan, the protocol can just liquidate the ETH I put up as collateral. As of 03–08–21, Compound’s collateral factors range from 0 to 0.9. As a lender, I can stake my ETH to the protocol for others to borrow from. In return, I’m guaranteed to get back my initial investment, plus interest. Looking on the website DeFi Rate, we see that as of 03–08–21, interest rates range from 0.2% to 8.72% with Stablecoins taking the higher interest rates due to the lack of volatility risk associated with the price of the underlying assets.
While this seems like it defeats the point of lending, over-collateralized lending is still fruitful. First of all, it reduces the risk to you since you can never lose more money than was originally put up as collateral, limiting your potential losses. Secondly, this kind of lending can be used as a kind of margin, a form of lending popular with financial services firms in which a user can borrow from a bank in order to make more investments. If the users investments are successful, they can pay back the loan and make money “for free”. Additionally, since the user will have invested a larger principal, their gains will be amplified. Look here for more information on Margin Trading.
Thanks for making it this far! If you haven’t seen the rest of the series, make sure to check out parts