Historically, banks and other financial institutions earn most of their revenue through DeFi lending. They extend loans to businesses through overdrafts and other credit facilities in exchange for annual percentage yield or APY-calculated interest. Some interest is also expressed as a yearly percentage rate or APR. The annual percentage yield is calculated using the formula (1+R/N-1)N-1 and represents an adjusted interest rate for compound interest.
The annual percentage yield (APR) or percentage rate is the money charged annually for a loan. APR is the interest rate on the borrowed amount plus the fees expressed as a yearly percentage of the borrowed amount. It provides a more accurate estimate of the actual cost of a loan and is higher than the interest rate when fees are associated with the loan. The annual percentage rate is computed using the formula F+Interest/Principal/number of days*365*100. It provides the monthly percentage paid on the principal.
In contrast to APR, APY is compounded. In decentralized finance, annual percentage yield (APY) and annual percentage rate (APR) are used to calculate the amount an investor will earn on an investment after a given period. The figures are frequently displayed in yield farms, and the higher the APR or APY, the greater the return on investment from a pool.
This article will examine the DeFi lending of crypto assets, DeFi loans, lending pools, DeFi protocols, DeFi borrowing, and other essential concepts. The objective is to explain DeFi in general, discuss decentralized exchanges, how crypto holders can earn, and the fundamentals of any protocol for decentralized finance. Regardless of your background or interest in DeFi, you will find this article useful, as we will discuss the fundamental concepts in depth.
WHAT IS DEFI LENDING?
Before discussing the specifics of DeFi lending, let’s review the fundamentals of any lending system. Lending is a component of conventional financial services, and interactions between lenders and borrowers drive the entire environment. Lenders have funds or crypto assets they intend to use after some time, whereas borrowers require funds for business or other purposes.
The Decentralized App Developer of DeFi smart contracts has devised a solution to this batter-type problem by enabling lenders to receive passive interest for keeping their funds on lending platforms. These platforms allow borrowers needing funds to obtain and pay interest to the lending platform. The platform charges a fee equal to the difference between the loan amount and the borrowing interest rate. At the same time, the return for lenders is calculated using the APR, and APY formulas described earlier.
For borrowers, on the contrary, DeFi lending is among the essential components of a decentralized system. DeFi protocols, such as AAVE or Compound, and CeFi companies, like BlockFi and Cel,cius make cryptocurrency lending possible. With centralized finance protocols or CeFi, loans and borrowing operate similarly to how they do in banks.
Centralized financial institutions are therefore known as crypto banks. BlockFi, for instance, uses the funds deposited on its platform to make loans to institutional players, hedge funds, and other platform users. Innovative, but not risk-free, are decentralized lending models for DeFi loans. There have been instances of bad loans, hacking, rug pools, and other forms of insider abuse. CeFi models are also antithetical to a central tenet of decentralization, namely the provision of asset ownership autonomy.
DeFi lending, on the other hand, enables users to become lenders or borrowers in a permission, decentralized manner that gives them complete control over their crypto assets. It is based on a code that runs on public blockchains like Ethereum and EOS. Lending and borrowing on DeFi are available to anyone without disclosing personal information or placing faith in a third party to hold their funds.
AAVE and compound are examples of DeFi lending protocols that create money markets for specific tokens such as ETH, stablecoins such as DAI and USDC, and other tickets such as Link and wrapped BTC. Users who wish to become lenders contribute their tokens to specific money markets on the platform and begin receiving interest based on the supply annual percentage yield (APY). The supply tokens are sent to a smart contract so other users can borrow them. In exchange for supply tokens, the underlying code issues permit representing supply tokens from these platforms plus interest on their deposits. These tokens are referred to as tokens on Compound finance and AAVE, and holders can exchange them for the underlying tickets.
Currently, all loans in DeFi are overcollateralized, meaning that the user who wishes to borrow funds must provide collateral tokens worth more than the loan token. There are various reasons why borrowers take out these loans despite having more than enough funds. Occasionally, these borrowers wish to refrain from selling their tokens but require funds to cover unforeseen expenses.
In addition to avoiding or delaying capital gain taxes, holders of these tokens may only wish to sell their collateral tokens if they are willing to close a trading position that could result in a profit. The amount that can be borrowed is contingent on two variables. The first factor is the number of available funds in a particular market, although, in active markets, this is rarely a problem. The second factor is the collateral factor, which is determined based on the token’s volatility. For example, the stable value of stablecoins allows users to borrow up to 75% of the supplied tickets.
If a user decides to borrow funds, the borrowed amount must remain less than the collateral’s value multiplied by the collateral factor. As long as the value of the borrowed amount is less than the collateral multiplied by the collateral factor, there is no limit on the length of time a user may borrow funds. The user’s collateral will be liquidated if its value falls below the required level.
The interest paid by borrowers is the interest earned by lenders, so the borrowed APY in a lending market is greater than the supply APY. Interest APYs are calculated per Ethereum block, and because APY is calculated per block, DeFi lending offers variable interest rates based on loans and borrowing demand. AAVE and Compound are distinct in that they offer variable supply and borrow APYs. However, AAVE also provides stable APYs and flash loans, which we will discuss later in this article. In addition to being variable over the short term, stable APY is fixed over a long time.
An example of a DeFi lending scenario can be comprehended better by examining an existing DeFi protocol. Let’s look at Compound Finance to learn digital asset borrowing and DeFi lending. When a user deposits funds to Compound Finance, the user receives several tokens equal to the amount deposited. These cookies will be required to recover the underlying ETH at the due date.
They calculate the exchange rate between tokens and the underlying ETH using a stable APY of 0.02%. The issued token accrues interest with each Ethereum block, even if it is moved to a different wallet. The supply to borrowed capital ratio determines the interest rate accrued by tokens. Assuming that in our example, the exchange rate of cloth, which is our token, to ETH increases by 0.0000000003 per block, the token’s supply will continue to increase.
If the rate of growth remains constant for a month, we can calculate the amount of interest that can be earned during that time frame. If every minute, five blocks are solved on the Ethereum blockchain. We can calculate the supply APY using 0.0000000003*4*60*24*30, which, when added to the previous exchange rate, yields a higher rate of 0.02005184. If a user decides to redeem an initial deposit of 10 ETH, they would have earned 0.2592 ETH in interest as a percentage return on their ETH. The original amount of ACTH does not change, but interest is made due to a change in the exchange rate.
Similarly to how good is accumulated with each block on the Compound, the same amount of interest is collected with each block on AAVE. However, on AAVE, the value of tokens is pegged at a 1:1 ratio to the value of the underlying tickets. This means that if you deposit 50 ETH on AAVE, you will receive 50 aETH, equivalent to the underlying ETH’s current market value. AAVE distributes the earned interest to awoken holders’ wallets. A holder of these tokens can redirect interest payments to a different address.
When borrowing on AAVE, borrowers lock their tokens as collateral and cannot redeem the underlying assets. The collateral factor of the supplied assets determines the maximum amount borrowed through AAVE. There are also codes on these protocols that calculate how much can be borrowed without immediate liquidation based on the collateral on the user’s account. AAVE occasionally uses the price feed of the Chainlink price oracle and comes up with its prices when necessary.
When users redeem their collateral, they must also pay the accrued interest on the borrowed assets. The accrued interest is determined by the loan’s annual percentage yield (APY) and increases automatically with each Ethereum block. DeFi lending is risky due to the program’s hackability. We will now examine code to comprehend what smart contracts, the foundation of DeFi, are.
UNDERSTANDING SMART CONTRACTS
Smart contracts are used to construct DeFi lending platforms. A smart contract functions similarly to an agreement in the physical world but is digital. On the blockchain, this is a piece of code that executes autonomously. With a smart contract, it is possible to create agreements and collaboration systems without relying on third parties.
A straightforward example of a smart contract is a crowdfunding platform like Kickstarter, which allows users to raise funds. If these users reach or surpass a predetermined goal, they receive project funding. If they do not, the fundraising will be cancelled, and the contributors will receive their money back. The contributions will be recorded automatically in a distributed ledger on the blockchain as soon as the fundraising campaign begins.
WHAT ARE DEFI LOANS?
How do crypto or DeFi loans function? What distinguishes them from conventional lending? This time, we’ll examine crypto lending in greater detail to comprehend how DeFi loans operate. You can borrow thousands or millions of dollars without approval with decentralized loans.
Centralized loans have made it difficult for many serious business owners to obtain funding for their enterprises. Financial institutions require your credit score and other personally identifiable information to ensure you will repay the loan amount. Using blockchain technology, decentralized loans have a different setup. DeFi or decentralized loans may be collateralized, similar to the preceding example with AAVE or compound, whereas flash loans are unsecured. Maker DAO, for instance, permits you to borrow against your deposited collateral.
The loan issued by Maker DAO corresponds to two-thirds or 66% of your initial collateral deposit. You will receive a guarantee of Ethereum to your connected cryptocurrency wallet upon repayment of your loan and interest. The principal is typically paid with DAI stablecoin, while the interest is paid with governance tokens or Maker. Maker is the governance token used to make crucial decisions within the Maker DAO ecosystem.
The DAO reduces the interest rate on Maker DAO tokens when there are fewer borrowers. The interest rate is increased when there is a surplus of borrowers, and when there are many unpaid loans, the rate is increased to encourage repayment and discourage loan requests.
Flash loans are a revolutionary development in DeFi loans. Without a social security number, credit score, or collateral, you can borrow a substantial amount of money through flash loans. You need only execute a single block transaction to return the funds. You may be unsure how to utilize a loan that must be repaid in the same transaction.
Arbitrage, which consists of buying cryptocurrency on one exchange and selling it on another, is the ideal example. For this process, platforms such as AAVE make it possible to borrow funds. Remember that a defaulting borrower is responsible for paying the loan’s interest. The procedure requires the lender to make sound lending decisions and the borrower to make sound borrowing decisions. Technically, a programmer must build a bot to detect price differences because they are transient and may vanish before you can take advantage of them manually.
OVERVIEW OF DECENTRALIZED FINANCE ACTIVITIES
Activities in decentralized finance utilize blockchain technology and the capacity to pay interest on borrowed funds or financial instruments. Since you already understand how a DeFi loan operates, you can view decentralized finance activities in a broader context. This is the case because there are numerous activities that we still need to consider in DeFi.
Consider a complete financial system comprised of decentralized applications. The only requirement for users is a simple cryptocurrency wallet and an internet connection, and they can generate a completely passive income stream by investing in DeFi. In the DeFi space, yield farming, liquidity mining, and staking are common phrases.
DeFi applications are created by a DeFi application development company with sophisticated mathematically secured algorithms, allowing users to sometimes earn more than their collateral value with a simple loan. The strategies may be quite sophisticated and involve substantial programming and mathematics.
Additionally, a physical asset can be tokenized and sold on the blockchain. The potential loan value is enormous with blockchain-based fintech applications or DeFi financial applications. Risk factors will also decrease as the DeFi space advances toward mainstream adoption. In a metaverse scenario, it will be possible to obtain loans by securing crypto assets that can be tokenized on the blockchain. The lending growth rate will be greatest for the protocols with the highest level of innovation.
As a result of the widespread perception that DeFi is too complicated, centralized exchanges are also prevalent today. The opposite is true, as DeFi is truly for everyone.
Lending pools are a collection of assets offered by lenders to earn interest on decentralized blockchain platforms. The underlying code of these platforms makes these funds available to borrowers, who then return these funds with interest to the platform.
Most borrowers are traders who anticipate an increase in the value of both the tokens they borrow and their collateral. Therefore, they do not wish to sell their collateral but require the borrowed asset. Some individuals attempt to avoid specific tax regimes.
We CAN HELP YOU BUILD A DEFI LENDING PLATFORM
We are masters in how DeFi lending works. Our in-house Decentralized App Development team will help you develop an interconnected software stack that is beneficial for DeFi lending. We are devoted experts in DeFi programming languages for multiple blockchains. As a platform with experience working on the same protocols as the largest lenders in DeFi and with large long-term investors, we make projects a reality. Your DeFi application can be different from those of others.
The total value that can be locked can range from small to large, and you can add additional user-friendly features to boost usage.
You are now familiar with APR and APY, DeFi lending and the example of how DeFi lending is structured. DeFi is a rapidly evolving industry that is gradually becoming the norm, as Generation Z and Millennials have grown tired of the baby boomers’ exclusive investment style. DeFi lending concepts may become more prevalent in a world of change and innovation.
There could be a combination of multiple features of existing platforms or entirely novel concepts conceived by creative minds. The best aspect of blockchain technology is that it facilitates the greatest degree of inclusion. Many have become millionaires because of flash loans, whereas NFTs have liberated artists. There is more to come in this emerging area of blockchain technology. If you are constructing your next DeFi project, contacting us could make all the difference. We hope that you now have a better understanding of DeFi and are prepared to thrive in the new financial landscape.
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