How to get a loan secured by your cryptocurrency and make money on it? If you do not know anything about stablecoins with cryptocurrency backing or lending in decentralized finance, read this article.
Stablecoins are cryptocurrencies whose value is tied to an asset: fiat currency, cryptocurrency, commodity, or a basket of all of the aforementioned.
Based on this, there are various types of stablecoins, differing both in the mechanism of their value formation and in the assets that provide their value.
This article is devoted to one of the very interesting mechanisms for the issuance of stablecoins backed by cryptocurrency. This process will also be referred to in the article as collateral lending, because it is a direct consequence of the issuance of such stablecoins.
This type of stablecoin can be called a decentralized stablecoin, since its value does not depend on the availability of fiat currency, and moreover, does not even depend on the rate of the cryptocurrency that provides it. This stablecoin cannot be blocked at the request of the issuer (like USDT).
The value of decentralized stablecoins is provided by excess collateral in cryptocurrency (the most common is on etherium), that is, the value is "borrowed" from the collateral, which has the properties of a commodity in this case (cryptocurrency can be perceived in two ways - both as a commodity and as money).
Usually, a person who first got acquainted with decentralized lending has a natural question: "Why should I pledge a certain amount of money (cryptocurrency) and receive a smaller amount of money in return, what is the benefit?" From this point of view, it looks like a loan to yourself.
The flaw in this conclusion is that the collateralized cryptocurrency is given the role of money, while it is a commodity (highly liquid) as collateral. Can't you see the difference?
That's right, it is conditional, but it makes it easier to understand the principle of lending in DeFi (as an analogy with a conventional loan secured by property).
Schematically, lending is carried out as follows: excess collateral is deposited, a smart contract creates stables that are received by the borrower. The borrower can at any time return the stables plus a certain percentage (called the stability fee, its analogue in an ordinary bank is the interest on the loan) back to the contract and get his collateral back.
If the value of the collateral falls below a certain limit (the ratio of the collateral to the loan is called the liquidation ratio - it means that below this figure the collateral can be sold; there is no direct analogue in an ordinary bank for the liquidation ratio, but a large delay on the loan can be remotely considered as such), the lender posts collateral to the auction, where he sells it for his decentralized stables, which he burns. This is necessary to ensure that all issued stables are always (even in excess) provided with the value of collateral.
The simplest example, excluding transaction costs: the borrower pledges 10 ETH and receives $ 4000 in stablecoins, while the ether rate is $ 600, that is, the collateral value is 150% of the loan.
The borrower buys 6.66 ETH for this $ 4000 and again takes a loan against the purchased ether on the same conditions (where it takes or from which address does not matter), that is, receives $ 2666.
The borrower buys again for $ 2666 about 4.44 ETH ... and, probably, that's enough for an example.
The day after tomorrow (or in a week) the ether rate rises to $ 800, the borrower sells his 4.44 ETH for $ 3552, returns $ 2666, receives 6.66 ETH, sells them for $ 5328, returns $ 4000, gets his 10 ETH back, and in addition, from the entire chain of loans, a profit of $ 886 + $ 1328 = $ 2214.
To be fair, let's say this is $ 2000 (discarding $ 214 as transaction costs).
Thus, if he just invest only in the ethereum, then with an increase in the rate from $ 600 to $ 800, the value of his asset would increase by only $ 2,000, and then he received an increase in the value of the asset by $ 2,000 and another $ 2,000 after the loan chain was repaid, that is, in the amount of profit $ 4000.
Not bad? But do not rush to take the next loan, first of all analyze where the rate of the collateral asset can go in the future.
You need to return the same number of stables to the contract as you borrow (regardless of whether the collateral value has become higher or lower at that moment), plus the interest on the loan (small). When the rate of the collateral asset falls - it is very unpleasant for the borrower.
If the price of collateral falls, they are put up for auction in certain packages (for example, 500 ETH each) and sold. Whose pledges go there? Those borrowers whose collateral value fell below a certain collateral limit - the liquidation threshold (this is the thing that is the liquidation ratio).
At the same time, a liquidation fee is withheld from the borrower for liquidation (it is called a liquidation fee and is an analogue of a fine for a delay on a loan in a regular bank, but here for the fact that the collateral had to be liquidated).
In the final, a situation is obtained in which the borrower has a fallen asset in his hands (if he has already bought it with borrowed stables), his collateral is liquidated, and a liquidation penalty is taken from him.
As you can see, in a growing market, the borrower is in profit, in a falling market, in loss.
The same cannot be said about the DeFi loan service. In a growing market, a service makes money, in a falling market, it does not lose, in contrast to the borrower. The reason for this is that collateral is a highly liquid asset. It is possible to draw an analogy with a conventional bank issuing loans for highly liquid securities.
But this is not always the case. Banks issue a huge share of loans against low-liquid assets, such as real estate. Then the borrower's problems become the lender's problems.
In DeFi, all the consequences of a fall in the value of collateral are borne by the borrower, whose collateral is used to maintain the stability of the decentralized stablecoin rate. Not a bad advantage over conventional banks.
Another difference between decentralized lending and traditional banks is that decentralized stablecoins have regulated emissions linked to collateral value.
Unlike an ordinary bank, where the equity capital is only a few percent, and the rest is just numbers on the accounts of loans issued (money issue by private banks), a decentralized service cannot issue unsecured money.
However, the collapse of the value of the collateral asset can become
a problem for the credit project due to the technical shortcomings of
the network on which it operates. If the network has insufficient
bandwidth, transaction delays happen.
Maker in the last spring can serve as an example, as a result of
which the collateral was sold at auctions for nothing, and as a
result, the situation didn't go well: there are no deposits because
they have already been sold for pennies, the extra DAI can not be
burned, because they are also sold out. And DAI which were no longer
sufficiently secured by collateral assets turned out to be in
circulation (you can easily find detailed information about this on
the Internet, if you want to).
Therefore, a blockchain project on which it is possible to build a stable and reliable system of decentralized finance must provide high network bandwidth, one of such project Free TON.
In the example above in the text, where the borrower operated on a chain of loans with 10 ETH, this amount was chosen for a reason. The fact is that if he started with 1 ETH, then all his potential profit would be gobbled up by transaction fees on the ether network.
Hence, the next important requirement for the blockchain for DeFi is that low transaction costs are required, which are needed in order to lower the threshold for entering financial services for their more massive adoption by users, which is exactly what Free TON has.
It is impossible to build a credit service right away and expect it to function on its own. At the same time, it is necessary to build other elements of decentralized finance. In particular, such an important component in the DeFi system as decentralized exchanges (DEX), without which lending does not make sense.
Imagine a market without Uniswap. Here are all financial transactions from the same example with 10 ETH, which should be carried out quickly and cheaply, would have to be carried out through centralized exchanges with withdrawal limits, with large commissions for this, and with the passage of KYC.
Also an important part of DeFi is the presence of bridges between blockchains, which allow liquidity to "flow" into the blockchain where the costs for users are lower.
Just this kind of work on building the most important components of the decentralized finance system is currently being carried out by Free TON developers in parallel with the development of stablecoins of various architectures, and we can learn about this first-hand from one of the developers, DeFi Sub-governance representative Aleksandr Vat, who kindly agreed to comment on the state of development of stablecoins in Free TON and other elements of the DeFi infrastructure:
Currently, contests have already taken place on DEX design, bridges architecture with Ethereum and Polkadot blockchains, as well as on atomic swap. The latter is more relevant for interacting with the Bitcoin blockchain.
The bridge with Polkadot actually provides interoperability with many blockchains, due to the purpose of Polkadot itself. Similarly, the bridge with Ethereum makes it possible to interact with all ERC-20 tokens of the Ethereum ecosystem, and therefore with many DeFi services on this blockchain.
Contest: FreeTon StableCoins Architecture & Design was launched in December. On February 5, voting on the competition ended. In total, 13 designs were presented.
To summarize, we can say that the competition was very productive, some projects, if not sufficiently developed in some way, contain very strong solutions in others.
By the way, taking this opportunity, I want to draw the attention of developers that some of the projects that go to DeFi Sub-governance or start are looking for developers for their projects.
Without a doubt, many projects will build a new future and you can become a part of this new world. If you want to dive into the world of DeFi, join the ranks and join the group.