Glossary
Lending and borrowing
Another use case for decentralized finance is peer-to-peer lending and borrowing of digital financial assets. Smart contracts carry out negotiation, and borrowers pay a fee to lenders. Everything happens similarly to what we are used to, but now anyone can lend and borrow with the security of a blockchain. Generally, users interested in lending their assets lock them into a contract, and they receive compensation for keeping the asset there.
The main difference in lending assets in a decentralized environment is that both parties do not need to be identified. Thus, there is no other way of guaranteeing the payment of the loan other than demanding the deposit of collateral from the borrower. Collateral needs to be greater than the amount borrowed to ensure loan repayment if the asset placed as collateral depreciates.
At first, it may seem strange for a user to deposit more money than he borrowed, but there is a good use case for this. Let’s say a person believes that bitcoin will appreciate and has some bitcoins. The person can put their bitcoins as collateral and take out some stablecoin on loan, using that stablecoin to buy more bitcoins. If bitcoin appreciates, the profit will be greater than keeping only the initial ones.
It is possible, however, for currency deposited as collateral to devalue. Usually, each protocol establishes a margin that must be maintained between the amount deposited and the borrowed one. If the threshold is reached, the collateral can be liquidated. This is done to ensure that the protocol never loses money, so lending in decentralized finance is risk-free.
This also allows third parties, not participants in the loan, to profit from it. As smart contracts do not carry out transactions by themselves, third parties are financially incentivized to interact with the contract to settle loans whose collateral has reached the established threshold. The collateral is liquidated to pay off the loan, and the third party executing the liquidation receives a fee.
One of the most used protocols for deposit and loan is the AAVE, which is present in several networks. Right now, there’s almost $6 billion of in assets locked up in the pool of their smart contracts.
There is also the possibility of protocols that can lend assets without collateral, however in this case, the borrowers cannot be anonymous. The decision to release or not the loan for a specific person or project would need to be taken collaboratively through voting using protocol
