The 101 of How DeFi Lending Protocols Work
Introduction to DeFi Lending Protocols
Decentralized Finance (DeFi) lending protocols are marketplaces which allow its users to lend, borrow, and trade cryptocurrencies in a decentralized and trustless way. They do so by facilitating liquidity pools, which are also referred to as token markets. These liquidity pools allow users to earn yield on the crypto assets they supply by enabling borrowers to borrow them.
Liquidity Pools on DeFi Lending Protocols
A liquidity pool is a smart contract on a blockchain-based platform such as Ethereum that allows users to supply their cryptocurrency into a pool of the same asset. Assets are pooled with other suppliers, hence the name pool. The protocol functions then allow these assets to be lent to borrowers who borrow the asset from the pool.
Liquidity pools providing borrowers with access to assets in this way is referred to as the provision of liquidity. When a borrower wants to borrow, they use their crypto assets as collateral, which may be in another pool, and borrow from the liquidity pool. In doing so the borrower pays interest, which is distributed to the liquidity providers in the pool based on their proportional share of the pool.
How Liquidity Pools Work
Users deposit crypto assets into a liquidity pool, with each pool designated by a single asset. The lending protocol then allows borrowers to borrow a predetermined percentage of the total amount in each pool.
In return, users gain a share of the interest the protocol collects from borrowing in the pool. The interest rate is determined by the supply and demand dynamics for each pool. If borrowing increases in proportion to the amount supplied in a pool, the interest rate for borrowing increases and conversely falls if the opposite is so.
Benefits of Liquidity Pools
Liquidity pools offer several benefits to both liquidity providers and borrowers. Interest can be thought of as the price of using an asset over time. For liquidity providers, lending protocols enable this process, with yield being earned on their crypto assets with the flexibility of withdrawing their assets at any time from the pool.
For borrowers, liquidity pools offer an immediate, trustless means of accessing liquidity without having to rely on traditional financial institutions like banks.
Lending protocols also issue users with additional rewards in the form of their native token for using the protocol, known as emissions. The value of emissions act as a form of interest bonus for suppliers and as a subsidy for borrowers, and in aggregate with interest earned may cause the protocol pools to deliver highly competitive outcomes.
Risks of Liquidity Pools
While liquidity pools offer several benefits, they also come with some risks. One of the main risks is liquidations. Most crypto assets can fluctuate dramatically in price. When a borrowing or lending position sees a rapid shift in the price of one of the assets, there is a risk of the borrower’s position becoming insolvent.
DeFi lending protocols almost exclusively rely on a collateralised lending system, meaning any borrow position requires the borrower to supply a greater amount of collateral to the protocol’s pools. When the value of that collateral decreases dramatically, or the value of the borrowed asset increases, the loan position can become insolvent. Insolvent loans are liable to liquidation, where collateral is sold off to repay the pool of the borrowed asset.
Another risk associated with liquidity pools is smart contract risk, which occurs when there are vulnerabilities in the smart contract code. This can lead to hacks or exploits that result in loss of funds for liquidity providers or borrowers. It is important to do thorough research and due diligence before providing liquidity to a liquidity pool on a DeFi lending protocol.
DeFi Lending Protocols and Yield Farming
Yield farming involves leveraging the value of the protocol’s emissions. The form and nature of emissions in lending protocols are specific to each one but commonly emissions are issued to both suppliers and borrowers of token assets in the liquidity pools. If the value of emissions earned subsidizes the cost of borrowing significantly enough, borrowers may participate solely to exploit such an occurrence, and this type of user behavior is known as yield farming.
A number of established yield farming strategies exist, including single-asset borrowing where users are seeking to exploit the value of emission rewards as well as strategies leveraging different types of crypto assets, such as stablecoins and non-stablecoins.
As recently witnessed in traditional finance with volatility in the banking sector, there are risks associated with financial services and lending protocols are no exception. They do however deliver significant upsides over traditional finance in the areas of flexibility and immediate and trustless access to liquidity, plus innovative and at times highly competitive yields.
The popularity of lending protocols has made them foundational to the overall crypto economy. For any economy to flourish it requires effectively functioning debts markets, which is what lending protocols have become. As the overall crypto sector grows in scale lending protocols will be key drivers and beneficiaries in enabling that future.
13, April 2023