Since the start of the blockchain era in the late 2000s, various businesses have been on the lookout to leverage the technology in some way or the other. After the dawn of cryptocurrencies, the financial sector joined, searching for ways to utilize the blockchains better. A long time later came the revolutionary concept of DeFi, a.k.a., Decentralized Finance – an idea that promises to be the banking sector for cryptos, albeit without any intermediaries.
In this blog, we will have a detailed look at what DeFi means, it’s working, and also a bit about major DeFi platforms that exist today.
What is Decentralized Finance (DeFi)?
As said earlier, decentralized finance (DeFi) is the new-age finance system that utilizes blockchain technology that works without any involvement of intermediaries. It truly serves as a peer-to-peer transaction system, although the central authority’s role gets replaced by the blockchain that hosts the DeFi system. The scheme aims for a transparent, open, fast, and permissionless transaction experience between its users.
Smart contracts are utilized to their full potential here as they can upgrade themselves based on the received information without any intervention from a third party.
Transactions can be of two types: DeFi lending and DeFi Borrowing. Let us see about them in detail.
Lending and Borrowing in the World of DeFi
In the DeFi world, lending and borrowing occur as real peer-to-peer (P2P) transactions. Here, crypto loans are offered without the involvement of any third-party authority. Crypto holders can also lend their cryptos through these platforms, and interest generated would add up as a passive income. Borrowers can directly take loans from P2P lending platforms, which work on DeFi principles.
How Does a DeFi Lending and Borrowing Platform Work?
- First, a borrower needs to create an account on the DeFi lending platform and attach their crypto wallet to the portal.
- Then, to get a loan in fiat currency, the borrower needs to keep some crypto assets as collateral, which is usually more than the loan value to take into account the volatile nature of cryptocurrencies
- As the borrower pays back the loan with interest, it goes directly to the lender, and they can earn passive income through the scheme
- As the borrower finally finishes paying back the loan amount with interest, their crypto collateral is returned.
- This can even happen in the role-reversed form, where a lender can lend cryptos for fiat money and then earn interest as passive income.
- This is essential as cryptocurrency sitting idle on the wallet cannot bring any passive earnings. The speculative thought of its exchange rate would increase in the future is futile judging by the current scenario.
- But why does the collateral need to be more than the loan amount? Here is why; The current cryptocurrency condition is volatile, so a one-to-one collateral value might go waste, as the collateral value might become lesser than the loaned amount. To tackle the issue, DeFi platforms came up with such a solution.
Features and Advantages of DeFi Platforms
- There is no central authority processing DeFi loans as everything gets written on smart contracts.
- DeFi platforms usually offer lower interest rates for borrowers, thus, relieving them from the trouble of a hefty repayment. Different portals charge different interest rates for different cryptocurrencies.
- Lenders can benefit from these platforms, as they get a higher interest rate for their deposits on the portal.
- Some platforms can provide so-called “Flash loans,” where one can get instantaneous loans, but with a condition to repay it within a stipulated time or the transaction gets canceled. For instance, the borrower needs to repay the loan amount plus a fee within the block cycle of the blockchain it runs on, or the smart contract does not modify, effectively canceling the loan.
- Also, interest rates can be switched between stable and variable by the users to get protected from the effects of the volatile action of cryptocurrencies.
- Some of the leading DeFi platforms do not impose any lower limit for lending or borrowing in their portals.
- Some DeFi platforms also host a fiat gateway for people who are not crypto experts so that they have a great experience and ensure the success of the portal.
Benefits of DeFi Platforms
- DeFi lending platforms, in general, offer higher loan processing speeds due to their cloud-backed nature, analytics for fraud identification and detection, and machine learning for optimum loan terms and risk factors.
- As the processes are backed by digital means, variations in evaluating applicant attributes are eliminated, and every applicant is assessed as per set credit policies.
- With the use of decision rules that play evidence for every loan transaction, the DeFi lender can be assured of complying with local regulations.
- From analytic data obtained in the DeFi lending portals, lenders and borrowers can know crucial information on the current loan scenario. If the user monitors the analytical data for a week, lenders can know the seasonal loan demand and allocate funds to the pool. Lenders can also get data on their borrowers’ demographics, credit tiers, and borrowers can understand the loan sources in detail. From there, users can improve their portfolios before the next transaction occurs.
- As already said, DeFi lending is permissionless and is truly a peer-to-peer process, meaning geographic location and minimum fund factors are eliminated.
- Since the public blockchain of the DeFi platform shows every transaction on it and every user needs to verify it, the process is perfectly transparent, and analytic data further improves the platform.
- Like any other blockchain-based product, information on a DeFi lending portal cannot be tampered with, increasing the levels of safety and trust in such platforms.
- The programmable nature of smart contracts ensures process executions are automated and new digital financial instruments are formed.
- Using an interconnected software stack, such DeFi lending platforms can ensure that their protocols and regulations efficiently complement each other.
- Since wallets employing Web3 technology (such as Metamask) are used, DeFi platform users are ensured that their data is under their control, and no outer authority controls it.
So, What Should I Do?
If you have read this blog until this far and have decided to venture into the trade of DeFi lending platforms, either as a lender or a borrower or even as the platform owner, you can get in without any doubt. But, ensure that you know all the relevant regulations around such platforms and how your local laws see them.
If you are an entrepreneur looking to start a new DeFi lending platform, hiring Blockchain App Factory as your developer can make your idea become a reality. Get in touch with one of our experts and start building on your vision now.