Dmytro is the founder of Solvid and Pridicto. Featured in Hackernoon, TechRadar and Entreprepreneur.
The growth of DeFi has been nothing short of meteoric, with investments in DApps and the use of applications snowballing over the course of 2020. With the development of low-cost DeFi loans as a viable alternative to centralized lenders, could we see the lending landscape change forever over the coming years?
To be considered decentralized finance (DeFi), a financial platform needs to feature one or more decentralized functions. These generally take the form of using distributed ledger technology, like blockchains, rather than storing records in a centralized manner. This places the decentralized governance of platforms in the hands of token holders, rather than a ruling board, meaning the use of decentralized information feeds and algorithms work to determine factors of loans like interest rates and currency values.
(Global spending on blockchain solutions. Image: Statista)
Most DeFi platforms take the form of decentralized apps, or DApps, as they’re commonly known. DApps use smart contracts to automate financial transactions, making them quicker, more efficient and much more affordable than the services that are offered by traditional banks or centralized loan companies. Because DApps are fully governed by computer code, they’re also naturally unbiased.
This automation has paved the way for some interesting new financial instruments to enter the lending landscape. Notably, ‘flash loans’ has entered the fray as a new form of loan that can be taken out and paid back in a single transaction. These loans enable users to borrow funds, convert or trade them across various platforms and then pay back the amount owed all within moments. Smart traders typically use flash loans as a means of taking advantage of cryptocurrency market fluctuations to generate a quick profit.
Perhaps the most exciting aspect of DeFi is how the ecosystem offers people more control over their finances as well as more interesting ways to use it. Centralized finance generally excludes individuals from its services, reserving the best instruments for those who have funds - contributing to increasing the wealth gap. However, DeFi projects aum to make investment and trading more universally accessible, with lower minimum investments and platforms that are easy to use via smartphone from anywhere in the world.
With DeFi applications like Maker and Compound, anyone can take out a loan of any size without having to disclose their identity to a third party and can be granted their funds in a matter of minutes. Typically, DeFi lending providers issue loans in stablecoins like DAI or USDC, with new platforms extending their capabilities to more volatile crypto markets like ETH, BAT, ZRX and REP.
All loans are primarily secured using cryptocurrencies as the underlying collateral, and with the development of smart contracts - blockchain-based contracts that can automatically be brokered and executed without the mediation of any third party or centralized middlemen - users can immediately pass the due diligence process by simply staking their assets in their blockchain wallet as proxy.
While traditional finance typically offers loans attached to significant interest rates, DeFi applications calculate a more complex but fairer system for interest. This calculation is made by using the ratio that exists between the supplied and borrowed tokens in a particular market. It should also be noted that the borrowed annual percentage yield can be higher than the supply annual percentage yield (APY) in particular markets.
As interest APYs are determined per Ethereum block, DeFi lending entails users being provided with variable interest rates that are liable to change depending on the lending and borrowing demand for tokens that aren’t tethered by real-world assets.
As we can see from the chart above, borrowing rates can vary significantly based on the DApp being used, but platforms like Maker and Compound offer consistently low composite borrow rates for users that are largely free of the wild fluctuations of other apps.
Additionally, some protocols like Aave offer users varied loan structures, like stable ‘borrow APYs’ and the aforementioned ‘flash loans’ - in these offerings, upfront collateral isn’t necessarily required.
Significantly, DApps are indiscriminate when it comes to issuing DeFi loans. Borrowers can be anonymous and the collateral offered can vary from app to app. Whether the loans can be issued for investment purposes, to better manage debt, or to pay for a significant event like a holiday or one-off purchase, DeFi packs the technology to action loan agreements on a peer-to-peer basis solely between the borrower and the lender.
With over 50% of us actively struggling to keep up with our bills, the arrival of smart financial management could be a watershed moment for the lending landscape.
Looking to a world of better financial inclusivity regardless of identity and credit history can be no bad thing.
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