How Do DeFi Lending Protocols Work?

Decentralized finance (DeFi) has emerged as a revolutionary force, creating financial products and services that are accessible, transparent, and trustless.

Lending protocols are a prime example of this, as they enable individuals to lend and borrow funds without intermediaries like centralized banks.

In this blog post, we'll explore how these protocols work, their benefits and limitations, and how to get started in the DeFi ecosystem. Whether you're a seasoned DeFi user or new to the space, this post will provide valuable insights into one of the most exciting areas of decentralization.

What Is DeFi Lending?

DeFi lending is a peer-to-peer approach to lending and borrowing that enables users to exchange digital assets directly on blockchain-based platforms.

Unlike traditional lending, DeFi lending operates on a transparent and automated system, allowing users complete control over their funds and to track their transactions in real time.

How Do Lending Protocols Work?

DeFi lending protocols rely on two essential components: smart contracts and lending pools. Lenders deposit their cryptocurrency into lending pools, which are then available for borrowers to borrow against by providing collateral in the form of other cryptocurrencies or stablecoins.

Smart contracts are the digital agreements that underpin lending protocols. They dictate the terms of the lending agreement between borrowers and lenders and automate the execution of loans.

When a borrower provides collateral, the smart contract transfers cryptocurrency from the lending pool to the borrower's wallet. The contract also manages the repayment process and can liquidate the borrower's collateral if they fail to meet the terms of the agreement.

Lenders earn interest on their deposited funds, while borrowers pay interest on the borrowed amount, as specified by the smart contract. Interest rates may be fixed or variable, depending on the supply and demand of the lending protocol.

Think of it this way: DeFi lending protocols use smart contracts to automate the lending process, and lending pools to provide liquidity for borrowers

An Overview of the Lending Process

Let's take a closer look at how the lending process works. Keep in mind that the process will vary depending on the protocol’s mechanics.

1. A lender deposits cryptocurrency, such as ETH, into a lending pool. The cryptocurrency is added to the pool's total funds and becomes available to borrowers. On most protocols, lenders are free to withdraw at any time. If there’s a lack of liquidity, APY increases to incentivize lending.

   
   

2. A borrower deposits collateral, usually another cryptocurrency or stablecoin, into the same pool. Most loans are over-collateralized– users provide more crypto than the loan is worth. This mitigates the risk of defaulting and acts as a buffer against fluctuations in the underlying asset’s value.

   
   

3. The smart contract governing the lending pool automatically executes the loan, transferring cryptocurrency from the pool to the borrower's wallet.

   
   

4. The borrower receives the borrowed cryptocurrency in their wallet and can use it for their intended purpose.

   
   

5. Yield is paid to lenders at regular intervals– every 24 hours, weekly, or monthly– that vary based on the protocol and smart contract.

   
   

6. Borrowers repay their debt (plus interest) to the lending pool.

Benefits of DeFi Lending Protocols

DeFi loans offer several benefits over traditional lending.

Transparency

DeFi lending protocols are built on blockchain technology, which provides transparency and immutability. All transactions on the platform are recorded on the blockchain, making them visible to everyone.

In contrast, TradFi transactions operate on centralized systems where processes are often opaque, and only authorized parties can access the data.

Low fees

These lending protocols operate on peer-to-peer networks, reducing transaction costs significantly as there are no middlemen (like brokers and central banks) to charge fees. Plus, smart contracts automate transactions, reducing the chances of costly human errors or fraud.

Accessibility

Anyone can participate in DeFi– regardless of their credit history. With an internet connection and crypto wallet, users can enter the ecosystem from anywhere in the world and borrow or deposit funds within minutes.

Conversely, traditional loans often require an extensive application process, including a credit and background check. These strict eligibility requirements make them inaccessible to large segments of the population.

Risks of DeFi Lending Protocols

Like any revolutionary idea, DeFi lending comes with risks.

1. Smart contract risk: DeFi lending protocols rely on smart contracts to automate the lending and borrowing process. However, they can have bugs or vulnerabilities that attackers exploit. For example, a coding error in a smart contract might allow an attacker to drain the funds in the contract, resulting in financial losses for users.

   
   

2. Market risk: The volatility of cryptocurrencies can cause significant losses for lenders or borrowers. For example, with impermanent loss, the value of a liquidity provider's investment can decrease due to changes in the price of assets in the pool.

   
   

3. Regulatory risk: As DeFi lending protocols are still largely unregulated, they may face legal and compliance issues in the future. Increasing scrutiny could impact the value of cryptocurrencies used as collateral or lent out in the protocols.

What DeFi Protocols Should You Try?

Joining the DeFi community can feel intimidating, even if you’re armed with practical knowledge. There are so many projects out there claiming to offer unmatched returns and a superior user experience.

Start borrowing and/or lending on these stand-out beginner-friendly protocols.

Sturdy Finance:

Sturdy Finance is a DeFi platform that allows users to access up to 10x leverage for yield farming.

Users can access Sturdy as lenders or borrowers, with lenders supplying liquidity by depositing stablecoins or WETH, and borrowers deploying these funds to whitelisted farms on protocols like Convex.

The yield earned from these farms is then split between lenders and borrowers, making it possible for lenders to earn more without borrowers having to pay more. Unlike many of its peers, Sturdy doesn’t have to charge high-interest fees to borrowers to generate income for lenders.

Gearbox:

Gearbox is a DeFi protocol that caters to passive liquidity providers and active traders/farmers. Passive liquidity providers can earn a low-risk APY by providing single-asset liquidity, while active traders/farmers can borrow those assets to trade or farm with leverage of up to x10.

Plus, users can take leverage from Gearbox and use it across various protocols, including popular DeFi platforms like Uniswap, Curve, and Lido.

Morpho:

Morpho is a DeFi lending pool optimizer that facilitates peer-to-peer matching between lenders and borrowers to enhance the capital efficiency of lending positions.

The platform provides improved rates for borrowers and lenders while retaining the same liquidity, liquidation guarantees, and risk parameters as the underlying protocol.

Users receive two rates: the APY of the underlying pool and a higher rate called the P2P APY, ensuring they always receive a rate equal to or better than the underlying protocol.

Unlock Financial Opportunities With DeFi Lending

DeFi lending protocols have disrupted the traditional lending industry by providing a decentralized, transparent, and accessible alternative.  As the industry continues to gain traction, we expect to see more innovation and development in the space.

It is important for users to understand the risks involved and to approach protocols with caution. However, with proper research, these protocols are a powerful tool for crypto holders to earn passive income and access funds without the barriers of TradFi.

Note: the author had a business relationship with Sturdy Finance before.