DeFi Financial Commodity Series: Decentralized Lending Platform

Let us first define what lending is: Lending refers to the financial behavior of using valuable assets as collaterals to borrow cash. In cryptocurrency, lending refers to the behavior of using cryptocurrency as a collateral to lend out stablecoins or other cryptocurrencies.

Borrowing and lending are very common operations in the cryptocurrency market. For example, if you have ETH on hand and are interested in BTC as well, how can you simultaneously invest in both? You can use ETH as a collateral to borrow stablecoins from a lending platform, and then use stablecoins to buy BTC. When both BTC and ETH prices rise, you can profit from both cryptocurrencies at the same time, and only pay the interest from borrowing the stablecoins.

If a price drop causes the borrower’s collateral value to drop by a certain percentage, the lending platform will then liquidate the collateral. These liquidated assets will then be returned to the lender, along with the interest due to the lender.

In a loan, there are two major players: the borrowers and the lenders. Borrowers make a profit by reinvesting the funds they have borrowed and lenders make a profit on the interest paid by the borrower. The major players for this dynamic in the cryptocurrency world are different from that of the current financial market. In traditional financial markets, loans are controlled by banks, pawn shops or other entities. In the cryptocurrency world, there are platforms that allow for normal users to be lenders. These platforms will only take a percentage of the interest earned by the lender as platform maintenance fee.

These lending platforms are the same platforms as the cryptocurrency exchanges previously mentioned. They can also be divided into centralized and decentralized platforms.

Centralized lending platforms can be further divided into two main categories:

  1. One type is a P2P platform, for example, Bitfinex. A lender can place an order and state his ideal interest rate, total amount and duration. A borrower can then decide whether or not they accept the order and its terms. Similarly, a borrower can also place an order with the total amount and interest rate they would like, and a lender can decide whether to take the order. In addition to matching up orders, Bitfinex also helps liquidate the borrower’s collateral if its value drops by a certain percentage. They then pay the funds and interest back to the lender.
  2. The other category of centralized lending platform is B2C platforms, for example: Nexo and Celsius Network. In this model, the lender entrusts his funds to a platform, which then broadcasts the lender’s fixed interest rate and looks for a borrower. The platform can then profit from the spread. For example: If the platform pays a fixed interest rate of 8% to the lender, but charges the borrower a 9% interest rate, then the platform will profit from the 1% difference in interest rate. Because this type of platform will chip at the lender’s profit, its interest rates are usually lower than P2P platforms. However, the advantage is that in B2C platforms a lender can stop lending and withdraw their fund at any time. In contrast, on a P2P platform, a lender cannot move their funds at any time before the stated date on the order.

It is important to note that both of these lending platforms are centralized platforms. So regardless of which one is being used, users will face some of the same issues as they do when using centralized exchanges:

  1. Users must register before using the platform and also go through a lengthy identity authentication process.
  2. Users must transfer their assets to the centralized platform and entrust the management and match up of their orders to the platform. This places even more importance to the security of the platform, and whether it will treat its users equally.
  3. There may be delays when users want to withdraw their funds. In particular, to avoid bank runs, platforms often limit how often users can perform withdrawals within a certain period of time.

In contrast, decentralized lending platforms like Compound and dYdX are putting blockchain’s decentralized traits to good use to provide lending services. Their solutions tackle some of the issues that centralized lending platforms have.

To start with: compared to the complicated process of registration and authentication in centralized platforms, decentralized platforms do not require any authentication. The lender only needs to have a digital wallet that can communicate with smart contracts to start lending. This solves the issue of identity authentication.

Second, decentralized lending is actually quite similar to the B2C model. This is because the lender’s assets are deposited in the liquidity pool, and then smart contracts assist in executing the loan. However, there is one main difference: all the information about the loan, including interest rate and total amount, are publicly available on the blockchain. This kind of transparency ensures that lenders know the most current interest rates, and that their expectations for interest rates are met. It also lowers the possibility that a loan was not executed successfully because of some unseen intervention by the platform.

Finally, with decentralized lending platforms, users can withdraw whenever and however often they want. Since information about supply and demand is open to the public, when there is less supply, the interest will naturally increase. This will attract more lenders to join and decrease the possibility of a bank run. This solves the issue of withdrawals that users face in centralized B2C and P2P platforms.

That being said, although decentralized lending platforms solve the problems mentioned above, they also present new issues:

  1. Since the user’s wallet is their account, the security of the wallet then becomes extremely important. Users must know how to protect and back up their wallet and private key to avoid any kind of losses that may happen due to accidents or security issues. This threshold may even be higher than an identity authentication process.
  2. All of the information, including the smart contracts, are publicly available. Some people believe open-source code is conducive to finding vulnerabilities in the code. However, there have indeed been incidents where malicious actors exploited loopholes found in the code. When users choose to use a decentralized platform to lend, there are issues other than interest rates that they must pay attention to. They must take a comprehensive look at other issues like the reliability of the platform, whether it has passed security reviews, and whether there is insurance in case losses are incurred due to a hacking incident.
  3. There are high miner fees. Even though funds can be withdrawn at any time, decentralized lending is still focused on Ethereum, where miner fees can reach around $30 to $50 USD. Lenders must pay close attention to ensure that they are still making a profit even after miner fees have been paid.

Based on what we’ve discussed, there are advantages and disadvantages to both decentralized and centralized lending platforms. Regardless of which platform a user decides to use, a good practice is to always start with a product that you are familiar with. Understand it thoroughly, and avoid making large sums of investments at the onset to ensure the safety of your assets.

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