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:
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:
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:
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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