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Leverage DeFi Lending and Borrowing to Ditch Your Bank and Grow Your Stack!

By Michael @ CryptoEQ | CryptoEQ | 24 Oct 2023


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Intro

In traditional finance (TradFi), lending and borrowing activities are facilitated by third-party financial institutions that play a crucial role in enforcing interest payments by borrowers and assessing the creditworthiness of parties involved. However, in the realm of decentralized finance (DeFi), trust in third-party intermediaries is replaced by trust in blockchain technology and smart contracts, resulting in novel mechanisms for on-chain lending processes.

A lending pool is an essential component of DeFi protocols, functioning as a smart contract that allows users to deposit assets, typically ERC20 tokens, with the intent of lending these assets to other users. Borrowers, on the other hand, can interact with the lending pool by depositing collateral assets, enabling them to secure instant loans.

Compared to traditional finance, DeFi lending pools offer significant advantages, such as:

  1. DeFi lending is not restricted by the 1:1 availability of funds for loans. Instead, a lending pool aggregates deposits from multiple users, creating a substantial inventory of tokens to accommodate loans on-demand.
  2. DeFi eliminates the need for rigid repayment schedules. Loans are issued against collateral, and borrowers have the flexibility to repay their loans whenever they choose.

The transparency and global reach of these lending protocols have effectively eliminated the need for traditional intermediaries such as banks. Traditional financial institutions often require extensive background checks that can be time-consuming. In contrast, on-chain lending protocols offer unrestricted access to lending markets. Moreover, the balances held by these protocols can be publicly monitored, ensuring that user assets are not lost due to poor management.

Most decentralized finance (DeFi) lending protocols currently offer only overcollateralized loans with variable interest rates. This approach provides greater control over capital allocation. For instance, if an asset is nearing full borrowing capacity on a protocol, the corresponding borrowing rates will sharply increase to deter further borrowing. Furthermore, the anonymous nature of DeFi precludes the use of credit assessments, thereby limiting the availability of undercollateralized loans.

However, the landscape is evolving, with newer lending protocols introducing specialized product features such as fixed-interest rate loans and undercollateralized loans. Notional Finance, for example, offers fixed-interest rate loans through liquidity vaults with predetermined loan maturities. This feature allows borrowers to accurately forecast the performance and risk associated with their positions. Similarly, Maple Finance provides undercollateralized loans to accredited borrowers. These innovative protocols offer predictable and capital-efficient loans, making them particularly appealing to institutional borrowers.

The Foundations of DeFi Borrowing

At the heart of most DeFi borrowing platforms is over-collateralization. Users can obtain an asset loan only if they deposit collateral valued higher than the requested loan. This practice starkly contrasts with traditional loans, where regular repayment schedules and fixed termination points are the norm. In the DeFi space, technically, a user might borrow and never be obligated to repay.

But, as with most financial instruments, there's an essential caveat. The collateral's valuation must consistently surpass the loan's worth by a previously agreed-upon margin. Failure to maintain this ratio may result in the immediate liquidation of the loan.

In the event of liquidation, an external party steps in to repay a portion or the entirety of the user's loan. As compensation, they lay claim to a corresponding segment or the whole of the user's collateral.

Irrespective of the myriad of DeFi platforms available, several foundational components remain consistent:

  1. Treasury: A vault or storage for safeguarding user collateral and the borrowed assets.
  2. Accounting System: An intricate mechanism to meticulously monitor each user's debt and collateral.
  3. Interest Rate Determinants: Algorithms or functions that dictate the interest rates applicable to borrowers.
  4. Collateral Verification Mechanism: Tools, often relying on external price oracles, to confirm if a loan remains adequately collateralized.
  5. Liquidation Pathway: A structured procedure for the liquidation of undercollateralized loans.
  6. Risk Management Protocols: Comprehensive systems that log pivotal safety metrics including total borrowings, collateral thresholds, over-collateralization ratios, and user-specific borrowing ceilings.
  7. User Interface: A user-friendly portal for clients to manage their collateral, initiate borrowings, and facilitate repayments.

Integration of Borrowing and Lending

While borrowing and lending are conceptually distinct operations, in the DeFi landscape, they often coexist within the same application. However, the integration between these features varies.

Platforms like Compound, Aave, and Euler exhibit exemplary integration. A symbiotic relationship exists between the interest rates for lenders and borrowers, ensuring the platform's smooth operation with minimal oversight.

Conversely, platforms such as MakerDAO and Yield operate as primary lenders, dispensing assets to borrowers. Notably, these platforms don't mandate users to contribute assets to facilitate borrowing for others.

Focusing on Borrowing

While lending is a critical aspect of the DeFi ecosystem, this article has chosen to spotlight on-chain borrowing. The complexity woven into the fabric of borrowing, particularly due to over-collateralization, warrants a deeper exploration. A profound understanding of the borrowing mechanism often serves as a gateway to comprehending the complete protocol.

In conclusion, as DeFi platforms continue to evolve, it's imperative for users and investors to fathom the nuanced mechanics of borrowing, ensuring informed decision-making in this decentralized frontier.

Risks

Lending and borrowing-based DeFi protocols are vulnerable to a number of attack vectors. Here are some ways that lenders and borrowers can lose out:

Lenders

  • Bugs that enable the principal due to reduce (possible to zero) without making any payments. This can happen if there is a bug in the smart contract that allows the borrower to reduce the principal balance without making any payments.
  • The buyer's collateral cannot be liquidated when the loan is not paid back or the collateral drops below the threshold. This can happen if there is a bug in the smart contract that prevents the protocol from liquidating the collateral when the borrower defaults on the loan.
  • If the protocol has a mechanism for transferring debt ownership, this could be a vector for stealing bonds from lenders. This can happen if there is a bug in the smart contract that allows an attacker to transfer debt ownership to themselves without the lender's consent.
  • The due date of the loan principal or payments is improperly moved to a later date. This can happen if there is a bug in the smart contract that allows the borrower to extend the due date of the loan without the lender's consent.

Borrowers

  • A bug where paying back the principal does not lead to principal reduction. This can happen if there is a bug in the smart contract that does not correctly update the principal balance when the borrower makes a payment.
  • A bug or griefing attack prevents the user from making payment. This can happen if there is a bug in the smart contract that prevents the borrower from making a payment, or if the borrower is the victim of a griefing attack.
  • The principal or interest rate is illegitimately increased. This can happen if there is a bug in the smart contract that allows the protocol to increase the principal or interest rate without the borrower's consent.
  • Oracle manipulation leads to devaluing the collateral. This can happen if an attacker manipulates the price oracles that the protocol uses to determine the value of the collateral.
  • The due date of the loan principal or payments is improperly moved to an earlier date. This can happen if there is a bug in the smart contract that allows the protocol to move the due date of the loan to an earlier date without the borrower's consent.

Both lenders and borrowers

  • If collateral is drained from the protocol, then both the lender and borrower lose out, since the borrower has no incentive to pay back the loan, and the borrower loses the principal. This can happen if there is a bug in the smart contract that allows an attacker to drain the collateral from the protocol.

As you can see, there are a number of ways that DeFi protocols can be hacked. It is important to be aware of these attack vectors and to take steps to protect yourself when using DeFi protocols.

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Michael @ CryptoEQ
Michael @ CryptoEQ

I am a Co-Founder and Lead Analyst at CryptoEQ. Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.


CryptoEQ
CryptoEQ

Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.

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