Alluo Academy — DeFi 101: Lending and Borrowing
Context
This is the beginning of the Alluo Academy series. Your source for clear, simple information on the world of DeFi.
For a brief introduction to what it is and a list of the topics we’re looking to cover you can read all about it here.
Intro
So we’re starting our Alluo Academy journey with a bit of DeFi 101. Taking it back to basics on Lending and Borrowing.
So what’s it all about?
Most people are aware of lending and borrowing in traditional finance, be it in the form of a car loan, mortgage, or similar. It is essentially the crux of finance; lenders provide funds to borrowers who get immediate access to the funds and then pay the loan back with interest over time. And historically all of this has been facilitated by banks or peer-to-peer lenders, who manage the process including setting the rules and the rates.
How does Crypto add to this?
With the rise of crypto has come so-called CeFi (Centralised finance) entities (e.g. BlockFi, Celcius RIP) who essentially operate in a similar way — they take depositors’ assets and offer a supposedly stable safe rate of return. In turn, they lend out these assets to other third parties with again supposedly low chance of default.
This supposed low risk has sadly proven untrue and 2022 has seen one CeFi lender after another fall by the wayside thanks to poor risk management.
In contrast, Defi lending and borrowing brings a step-change in efficiency, access, and significantly, transparency over both CeFi and traditional money markets. So whilst DeFi lenders could fall foul to similar poor risk management and ill-advised investments, it would be all on-chain, fully visible and customers could withdraw their funds immediately.
So what does lending & borrowing look like in a DeFi context?
Put simply — individuals can both lend and borrow cryptocurrencies without the need for a bank or other financial intermediary.
Customers can access funds at all times (i.e they don’t need to hand over custody of funds to a third party). But above all else, ANYONE can borrow and lend in DeFi. There are no rules about your background, location, or financial experience. You simply need some cryptocurrency to take part. 👀
Instead relying on people and centralised firms, everything is managed by smart contracts on completely transparent blockchains (currently most predominantly on Etherium and other EVM-compatible chains and layer 2s). Lenders can deposit to a lending protocol and borrowers will borrow from that protocol without the need for any person-person interaction. Customers can usually repay or withdraw from protocols at any time.
So how does it work?
Lending
When depositing funds in a protocol such as Compound, Aave or Maker Dao to become a lender, customers not only receive interest on their deposit (often in the form of reward tokens), but they receive additional tokens native to that protocol in return.
For example, if a customer deposits ETH into Compound their deposit immediately starts earning interest (from other users borrowing funds and paying for that privilege). However, interestingly they are also given an equivalent value of cETH is received in return.
These cETH can be held onto, or more interestingly used elsewhere in DeFi — e.g. as collateral as a loan. So in case that hasn’t sunk in, they can essentially be spent whilst still earning interest.
We’ll come back to this later.
Borrowing
Typically in DeFi the majority of borrowing is done on an over-collateralised basis. That is to say, borrowers need to put down an amount of crypto that is more than they want to borrow. While this may seem counterintuitive at first, this allows people to keep hold of assets they expect to appreciate whilst still freeing up capital to spend today.
These loans are over-collateralised because borrowers have a maximum amount they can draw relative to the initial deposit.
So for example, if Sarah deposits 10 ETH in her protocol of choice and the maximum amount she can borrow is 75% of that deposit, she will only be able to borrow crypto with a value of 7.5 ETH. She will be charged a borrowing interest rate for doing so.
However, it’s worth noting that typically people won’t take the maximum as crypto asset prices are volatile, and breaching the maximum loan to collateral amount results in “liquidation” of the deposit capital. This is the process whereby the smart contracts automatically sell some of the collateral to pay back a portion or whole of the loan — often at a discount.
Getting a bit more pro-Degen about things
Those paying attention will recall that liquidity providers not only receive interest but also tokens in return for their deposit. Those ahead of me will realise that this creates some interesting options.
For example, Joe could deposit $10k in Aave immediately start earning yield and also receive $10k worth of A tokens. He could take these tokens deposit them back into Aave as collateral and borrow up to $7.5k out again. He could then deposit this back into the AAVE lending farm and start to harvest the yield and continue this loop many times over.
Assuming his yield on the lending side outweighed that on the borrowing side AND critically, his asset price was stable so that his borrowing amount never exceeded the maximum he was able to borrow, he would be able to make good returns from this leveraged strategy.
Whilst exciting, this is also potentially very risky. Maximising gains like this increases risk every time a loop is run, so users enter into such schemes at their own risk!
So are there any more innovative things I can try out?
Of course, one such innovation is something called flash loans. These don’t require any capital at all and the borrower uses the funds and repays the funds in the same on-chain transaction. This is a highly efficient solution that can be used for instant arbitrage and refinancing. But typically requires deep understanding to understand the risks let alone set up and run.
These examples barely scratch the surface. So we will return to these in more depth in a later article.
Conclusion
In its short life to date, DeFi has started to make complex borrowing and lending options available to many more people worldwide. However, accessing them can be difficult and costly (both in gas fees and mistakes caused by the difficulty).
This is where Alluo comes in. The protocol makes complex DeFi strategies available to all whilst helping reduce the cost and complexity.
How do I find out more and get more involved?
Check out our Blog for more AlluoAcademy articles and jump into Discord to talk to the team and community for more insight.
Those that have more to say and want to contribute to the Academy can also hit us up there and make some suggestions!
