Decentralized Finance: Perks and risks associated with DeFi lending.
The decentralized Finance (DeFi) lending protocol like all other DeFi groups is built on top of the blockchain network. This means it is open source, transparent, permissionless, and operates with no central authority. This gives users full access and control over their assets.
DeFi lending works by users contributing to the pool of capital by depositing their crypto assets to be lent out to those who seek loans with collateral. This type of lending has two types of rates, on deposits and on loans. On deposit is the interest, an investor receives and on loans is the interest the lender must return.
How do you calculate the interest?
This depends on two factors with the first factor being the amount and demand of the loan for the cryptocurrency in which the loan is issued. The second factor is the asset that is used as collateral to obtain the loan. It is safe to say that these rates change and they range from 2% to 10% depending on the service platform.
In comparison to traditional lending, DeFi lending comes with a couple of advantages and its own share of risks. Let’s look at some of its perks to its end users.
- Eliminates intermediaries.
DeFi loans have mange to eliminate middlemen, unlike the traditional lending system. The peer-to-peer transactions through smart contracts allow lenders to borrow more at low-interest rates while lenders get to earn more for every loan obtained.
2. Direct access to the market
By removing middlemen, DeFi lending becomes an open market for anyone who has internet access to participate. This is not restricted to anyone’s credit history, or geographical location, as long as they have a crypto wallet, they can participate in lending or borrowing. The inclusivity encourages more people to participate and contribute to the pool.
3. Transparency
DeFi lending is built on a public blockchain network meaning that every transaction is open, public, and transparent to anyone. Users are identified by their wallet address hence anyone can see the transaction history, the smart contract used to educate themselves on the DeFi protocol.
4. Immutability.
With blockchain technology, every transaction added to the block is time-stamped. This makes it difficult to erase or change any transactional information. Whatever is agreed between the two parties is recorded and secured and can’t be changed.
5. Improved Speed for Loan Approval
Thanks to technology such as cloud-based services, machine learning algorithms, and analytics to prevent fraud, DeFi lending offers a fast processing speed for loan generation. This technology speeds up the loan processing and as soon as it’s approved, it offers e-contracts to the lenders.
6. Anonymity
Despite DeFi loans being open and transparent, it gives its users anonymity by recognizing its users through their wallet addresses. Anonymity ensures that anyone from any location in the world despite their credit history can access the loans as long as they have collateral. This minimizes biases in loan allocation.
7. Simplicity
DeFi loans are pretty straightforward. You do not require any history or paperwork to obtain the loans. Once you request a loan, get verified you can access the requested loan. All this is processed using a smart contract.
8. Self-custody and interoperable
Users of DeFi protocols have full custody of their assets. They can manage and control their assets and through interconnected software, DeFi protocols and applications can integrate together. For example, a user can connect their wallet address to the lending protocol. A lender can connect the DeFi lending protocol to Kotani Pay and off-ramp their assets directly to their mobile money.
9. Better rates
DeFi lending offers lucrative annual percentage yield rates than traditional banks where rates that were under 0.5% are closer and are in the double digits. DeFi loans also offer low-interest rates for borrowers of an average of 2%-10%, unlike traditional lending platforms. These rates encourage investors to lend out more and borrowers to take more loans due to the low competitive rates.
Now that we know the benefits of DeFi lending to its end users, what are some of the risks that come with it?
- Impermanent loss
This happens when the price of assets in a liquidity pool changes after being deposited mainly because of the volatility of crypto tokens creating an unrealized loss in comparison if the user stored the money in their crypto wallet. DeFi pools have to maintain a ratio of assets in the pool with two tokens. When liquidity providers add one token to remove another, they change the ratio and in order to regain the balance, the liquidity pool increases the price of the token in high supply to encourage traders to rebalance the pool. Once it rebalances the value of the liquidity pool is less than the value of the asset held by the lending protocol. Stablecoins contribute to the mitigation of such losses through their less volatile nature.
2. Flash loan attacks
This is when bad actors borrow a huge amount of money using flash loans which are basically unsecured loan that uses smart contracts to mitigate all the risks associated with traditional banking. A flash loan is a huge loan taken in crypto assets without any collateral but one has to pay the full amount back within the same transaction it was sent. So in this case, the bad actors then use these flash loans to manipulate the market or exploit vulnerable DeFi protocols for personal gain. This results in exposing the liquidity pool to impermanent loss and causes investors to lose confidence in the projects.
3. DeFi rug pulls
Rug pulls are a type of exit scam where DeFi developers create a new token and pair it with a leading cryptocurrency and set up a liquidity pool. Through marketing strategies, they encourage people to deposit into the pool with a promise of high yields. When the pool fills with a substantial amount of cryptocurrency, the developers mint millions of new coins that they sell to popular cryptocurrencies such as Ether through a coded back door in the smart contract. The result is drained of the popular crypto from the pool leaving worthless coins behind. DeFi rug pulls and exit scams account for 99% of blockchain-related fraud activities and $329 million of all DeFi hacks and scams.
How then do you avoid such risk? Fear not, despite the DeFi technology being new and not fully dress-tested over a long period of time, these risks can be mitigated. First, be aware of projects promising high yields with aggressive promotions and marketing. Also, make sure you do your research on lending platforms. Check if their projects have been audited by a third party. Also, check if they have cybersecurity that will protect your assets.
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