The decentralized finance space offers a platform where borrowers meet lenders without intermediaries and arbitrators, eliminating the need to trust each other. This opens up the opportunity for cryptocurrency owners to place their tokens in credit pools, while borrowers can directly receive funds from lenders through smart contracts.
Whenever a user wants to lend their cryptocurrency on a DeFi lending platform, these tokens are deposited into a credit pool from which any borrower can obtain a collateralized loan. Smart contracts connect lenders and borrowers.
Lending protocols allow for relatively quick and accessible borrowing, while providing passive income to independent lenders. To ensure the security of cryptocurrency lending, overcollateralization practices are often employed, requiring collateral worth approximately 1.5 times the loan value.
To obtain a DeFi loan, there is no need to undergo checks, provide documents, or wait for confirmation. Anyone can almost instantly take a loan against their token collateral.
The technology itself aims to create a transparent ecosystem of financial services with open-source code, accessible to everyone, and fully decentralized (without a single regulator). Users must maintain full control over their assets and interact with this ecosystem through decentralized applications (dApps) or their web interfaces.
How to invest?
All you need to earn on lending is to have some savings in your cryptocurrency wallet and "sign" a couple of smart contracts on one of the credit pools. There are dozens of them on the market, but the most popular ones are AAVE, Compound, and MakerDAO.
To start using any of these applications, you need to have at least $1 worth of tokens supported by the chosen platform in your wallet. Users deposit their tokens into smart contracts through the platform's regular web interface and receive "liquidity provider tokens" in return.
Holders of such tokens can vote on any further project changes, ranging from how the protocol should allocate its funds to more specific details like collateral factor adjustments. These voting or governance tokens can be freely traded on decentralized exchanges, allowing them to be exchanged at any time without waiting for loan repayment by the borrower.
How to choose a platform?
Lending protocols are one of the fastest-growing sectors of the cryptocurrency market, resulting in the regular emergence of new projects that compete for investments and offer the best conditions for borrowers. Most protocols have a flexible interest rate system aimed at benefiting all three parties involved: the protocol, borrower, and lender. The market situation changes several times a day, making it quite challenging to find truly favorable offers.
To address this issue, advanced mathematicians and programmers have created a new class of assets that automate the selection of the most profitable platforms for investors to engage in farming or lending, distributing the earned assets to their contributors.
The initial projects of this kind caused a sensation in the market. During the height of the DeFi market's development in mid-2021, the Yearn.finance project gained attention far beyond the cryptocurrency community. It was the first notable case where a cryptocurrency surpassed Bitcoin in value.
These projects are designed to autonomously move investors' funds to platforms with the most advantageous offers. This became a revolutionary breakthrough in the industry due to significantly increased profitability for investments in stablecoins.
The model proved so successful that currently, YFI provides higher returns than any of its individual sources.
What are the risks and downsides?
Among the disadvantages of lending services, we can highlight the less user-friendly and comprehensible interfaces. Additionally, DeFi lending protocols require an understanding of how cryptocurrency wallets and blockchain networks function, as well as complex interest calculation mechanisms.
Furthermore, lending protocols in the DeFi environment are not regulated by any authority, and their smart contracts are potentially vulnerable. Such investment options do not fall under any regulatory framework, and the deposits themselves are not insured.
Decentralized financing still has some drawbacks that may hinder its growth, but the industry continues to actively develop. The new market impetus, expected to begin in the coming year, will contribute to increased lending profitability.
This article does not constitute individual investment advice, and the financial instruments or operations mentioned may not align with your investment profile, goals, and expectations. The material is prepared for informational purposes only and does not contain any calls to action or information that may be deemed illegal at the time of publication.
Conduct thorough analysis before buying and using any DeFi tokens.