Decentralized Finance: How does DeFi lending work?

Blockchain technology has interrupted our way of life including how we obtain money. The network transcends borders, ensuring financial access for everyone. This has resulted in the emergence of fintech building around the technology and expanding financial services and opportunities. More fintech companies built on blockchain technology are offering financial services such as borrowing and lending, saving, and investments.

The concept of borrowing and lending is familiar as it comes in the traditional form of mortgages, SACCOs (Savings and Credit Cooperative Societies), lending apps, student loans, table banking, and buy now pay later. These services are prominently seen in financial institutions such as banks, micro-lending platforms, and SACCOs that require one to have an account with them and a good credit score to be able to borrow. These centralized financial institutions get to regulate the loans, interest and who gets it. Decentralized finance has changed this by eliminating financial intermediaries such as banks and replacing them with smart contracts built on the blockchain network.

What Is Decentralized Finance?

Decentralized finance popularly known as DeFi in the simplest explanation is the financial ecosystem that is built on blockchain technology and operates without the need for a third party or a central party. DeFi uses a peer-to-peer communication model where each party is equal with equal access to data and directly communicates with each other. In this case, DeFi enables each party to manage their assets regardless of who they are and where they are. Their operations are transparent, open-source, permissionless, and equal leaving no room for bias.

DeFi is made possible by a smart contract. Smart contracts are self-executing programs that run on blockchains. They are computer programs that automate transactions by executing commands in response to meeting an agreed condition. It could be a buyer and seller smart contract agreement where a digital asset is released once the buyer deposits an agreed amount of money. The smart contract will facilitate both ends of the agreement and ensure that all conditions are met for the transaction to be executed. In such cases, the buyer and the seller are directly dealing with each other through the smart contract and eliminating any need for middlemen in the process.

Smart contracts work in real-time hence saving time and inconvenience of movement in order to execute the transaction. Smart contracts offer irreversible, traceable, and transparent transactions to both parties. Just like how traditional contracts regulate personal and professional lives, smart contracts make each transaction, safe, secure, and highly functional in an organized way.

For smooth functioning of transactions and contracts, DeFi systems rely on layers ie the settlement layer, protocol layer, asset layer, application layer, and aggression layer. The protocol layer is essential for the DeFi system as it provides access to financial services allowing buyers, sellers, lenders, and borrowers to be involved in real-time peer-to-peer transactions.

According to DeFi pulse, the total value of DeFi has increased by four times since July 2022 when $9.1 billion of value was locked in DeFi. In July 2022, it is estimated that $38 billion of value is locked in DeFi. This is mostly attributed to the exploding investments in cryptocurrencies. More people are embracing blockchain, in fact, as of now, there are more than 80 million blockchain wallets globally, an increase of 35 million wallets in the last 2 years. The positive adoption of DeFi creates a conducive ecosystem for other financial services such as borrowing and lending.

DeFi lending and borrowing

So what is DeFi lending?

DeFi lending is the use of platforms that offer crypto loans using smart contracts. Users can become lenders or borrowers with full control of their digital assets. Smart contracts facilitate the P2P (peer-to-peer) lending process. Through the lending protocol, both the borrower and lender benefit. The lender can deposit funds and earn interest on supplied stablecoins and cryptocurrencies. Borrowers on the other hand can access fiat credit at lower interest rates than centralized financial platforms. Also as a lender, you could also borrow tokens against your deposited tokens as collateral.

How do DeFi loans work?

Stored digital assets in wallets don’t earn any passive income. DeFi allows anyone to be a lender. In this case, one can deposit fiat currency or crypto token to a lending platform and through the help of a smart contract, receives back their fiat or digital assets with interest-earning them a passive income.

Borrowers on the other hand deposit crypto assets with a higher value than the amount of money they intend to borrow as collateral in order to obtain a crypto loan. Once they repay their loans with interest, they receive back the deposited collateral.

The smart contract facilitates both transactions where the borrower deposits crypto assets of high value such as Celo to obtain a crypto loan such as cUSD while the lender deposits fiat currency or a crypto token such as cUSD. Once the borrower pays back the borrowed crypto loan with interest they get back their collateral failure to which, their deposited crypto assets are liquidated in order to pay back the lender.

How is DeFi lending different from Traditional lending?

For one in DeFi lending, anyone can be a lender and a borrower and earn interest. Both the lender and borrower benefit from the transaction. Long-term investors can earn interest from lending out their assets. Borrowers get to access loans at lower rates than traditional financial institutions and access fiat currency credit. With DeFi lending, there is no bias on who gets the loan or preferential treatment among users as they all remain anonymous and are only recognized by their wallet addresses.

DeFi lending also offers transparent transactions with no third party involved. No personal information is required to either borrow or lend using DeFi. Users only need to create an account or connect their existing crypto wallet on the selected DeFi platform to access the services. Unlike traditional financial institutions, anyone can access DeFi loans anywhere in the world at any time of the day without any special requirement like a credit score as long as they can deposit the collateral.

How does the Kotani Pay DeFi lending work?

DeFi lending has opened up new financial opportunities for people to access loans anywhere in the world. The greater the DeFi pool, the larger the liquidity. These are opportunities that increase financial inclusion, especially in Africa as a majority of them still remain unbanked.

One of the many Kotani Pay use cases is DeFi lending. At Kotani Pay, we enable lending institutions to distribute these loans to their borrowers and to off-ramp their DeFi loans to their mobile money wallets. This is mostly suitable for microfinance institutions that require liquidity to offer out loans to a group of beneficiaries who have no bank accounts.

These microfinance first deposit crypto collateral to lending platforms such as Moola. Once they obtain their DeFi loans, Kotani Pay steps in to facilitate the distribution of the loans to the borrowers. This starts with us doing the KYC for your microfinance borrowers which gives them a Kotani Pay wallet address that becomes their blockchain wallet address. The DeFi loans are then distributed to each Kotani Pay wallet that can be accessed using our user-friendly USSD code. The borrowers then off-ramp the received money to their mobile money in the form of local fiat.

Kotani Pay makes it easier to obtain these loans using their mobile money hence facilitating access to DeFi loans for marginalized people.

Become a Kotani Pay insider. Get the latest news and product updates conveniently in your inbox.