Out of all industries, finance is one such sector that has been largely dominated by centralized entities since its inception. However, decentralized finance, or DeFi, has started a new approach. DeFi has seen a massive increase in use over the past two years.
What Is DeFi?
In simple terms, DeFi allows people to access financial services such as borrowing and lending using cryptocurrency without needing a traditional bank. According to the Dune Analytics report in early 2022, over 4 million unique users were using DeFi applications, resulting in over 40x growth since 2020.
What Is DeFi Lending?
DeFi loans are a type of loan that is issued and managed through DeFi platforms.
For example, let's say you want to borrow money from a bank. Then, the bank would review your credit history, income, and other factors, and if it approves, you will get a loan. So, here, the bank acts as an intermediary facilitating the loan between the borrower and the lender and collecting interest as a fee for providing the service.
On the other hand, in DeFi, you want to earn interest on your cryptocurrency holdings. With DeFi, you could lend your cryptocurrency to a decentralized lending platform, where borrowers can borrow your cryptocurrency and pay you interest in return. This process happens automatically through smart contracts, without a bank needing to intermediate the transaction.
How Does DeFi Lending Work?
DeFi loans are typically collateralized, meaning borrowers must provide a certain amount of cryptocurrency or other digital assets as collateral to secure the loan. The smart contract holds the collateral in escrow and is automatically returned to the borrower once the loan is repaid.
Interest rates for DeFi loans are set based on supply and demand and are determined by the lending platform's algorithm. DeFi loans can offer competitive interest rates, as they are not subject to the same overhead costs as traditional banks.
What Are The Advantages Of DeFi Lending?
Ensures transparency: DeFi lending platform transactions are visible on the blockchain, ensuring transparency. This enables users to confirm that the platform functions properly and their funds are managed correctly.
More accessible: It is more accessible than traditional lending because anyone with an internet connection can participate, regardless of location, without needing a good credit score.
Lower fees: DeFi lending platforms typically charge lower fees than traditional lending institutions, making borrowing and lending more affordable for users.
Offers flexibility: DeFi lending platforms offer a range of lending and borrowing options, including the ability to customize loan terms and collateral requirements. This allows users to tailor their borrowing and lending to their needs and risk tolerance.
Security: DeFi lending platforms automate lending and borrowing transactions using smart contracts. These contracts are executed automatically, eliminating the need for intermediaries and reducing the risk of human error or fraud.
What Are The Drawbacks Of DeFi Lending?
Volatility risk: The value of cryptocurrencies can be volatile, making it difficult to price loans and collateral accurately. This can lead to sudden changes in collateral value and potentially lead to liquidation events.
Regulatory risk: DeFi lending platforms operate outside of traditional regulatory frameworks. This means they may be subject to legal and regulatory risks, including potential government intervention.
Limited liquidity: DeFi lending is still a relatively new and niche market, so liquidity may be limited. This can make finding loans or borrowing funds at competitive rates difficult.
As adoption and awareness of the DeFi sector continue to increase, these risks will probably gradually diminish.
DeFi loans offer borrowers an alternative to traditional lending, with more flexible terms and lower fees. They also allow investors to earn interest by lending their cryptocurrency holdings to borrowers through decentralized lending platforms.
(The author is the CEO and co-founder of Mudrex, a global crypto investing company)
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