Thanks to decentralized financial applications, there are now more opportunities for you as a consumer when it comes to what you can do with your money.
Before we get started we have to take a brief look at legacy financial services. When you take out any type of loan you are generally going to have to pay interest on the amount borrowed. The creditor is going to assess your financial situation and look at your creditworthiness, and decide how much they should give you, how much interest you owe, and how long to pay it off. These interest rates can be astronomically high. The average interest rate on a payday loan is 391% average interest rates for alternative choices like credit cards(15%-30%); personal loans (14%-35%) and online lending (10%-35%).
In some of these situations you might not even qualify for the loan. In all of the situations you are not going to earn any interest at all.
Now thanks to blockchain technology we can enter into collateralized debt positions (CDP's). To make things simple, just imagine it as a pawnshop run by your loving Grandma that you can call at 4AM to ask for more cash. In a pawn shop you put up a form of valuable collateral such as jewelry or a tv set, and in return you get a high interest loan for less than the amount of what the items could sell for. If you can't return to pay off the loan in the agreed timeline they sell the item you left them so they can cover the debt you owe them. The pawn shop can also refuse to loan you money if you bring in junk.
The CDP works in a similar fashion, but with more freedom. When you open a CDP you put up collateral in the form of the cryptocurrencies Ethereum or Basic Attention Token. From there you can decide how big of a loan you want to take out. The amount of collateralization and the loan determines the risk to the creditor. This risk is called your collateralization ratio. At any point that your collateralization ratio drops below 150% the blockchain application sells your assets to cover your debt. You will get your collateral back, but it wont be as much as you originally put in because the application will collect a penalty fee (13%).
This is a random loan I picked out to show as an example. In this picture we can see that if the price of Basic Attention Token reaches $.15 then the contract owner will lose some of the 225,000 BAT he has put into the contract. The contract will self execute and spend the BAT to pay his (Outstanding DAI Debt) this is seen in the right hand column. To put it simply DAI is a stablecoin. Just think of it like $1 USD. The price only fluctuates a few cents higher or lower than $1.
From this example we can see that the contract owner has a $22,528 loan. The contract owner put $47,000 worth of collateral down to cover the loan. You can also see the current price information for BAT is $.21. As the price fluctuates the collateralization ratio will fluctuate. At any point in time the contract owner can increase their collateral or pay back debt maintain the ratio they feel comfortable with. Now I will show you what the current contract looks like today.
As you can see the contract owner added more collateral as the price went down. This lowered their liquidation price, and also raised their collateralization ratio. You can also see that their debt changed. This is probably due to the stability fee (4% APY) which is the interest you pay.
At any point in time the contract owner can take out a bigger loan by generating more DAI.
So now how do I earn interest instead of paying it?
So now we have learned a little bit about CDP's and loans we can adjust on the spot. What we have to do next is loan out the loan. When I created a CDP I took my DAI and traded it for Basic Attention Token. From there I moved it over to crypto.com and used their earn program that allows you to generate 6% APY interest when you create a loan contract that they manage. There is a 1,250 BAT minimum and a contract term limit of 3 months. So this means that I cannot touch what I deposited for 3 months, and I will only earn 1.5% compounded interest for that term. 4 contracts would add up to 6% APY. Theres also an option to earn 8% but this requires purchasing roughly $2000 worth of another asset. It could be worth it to do depending on how much BAT you are loaning.
There are many risks involved in this process such as price fluctuations, managing your own assets, security issues etc etc, so approach at your own risk. Price fluctuations can easily cause you to pay down debt or put up more collateral to reduce liquidation risk. Price fluctuations can however also reduce some risk if the price rises above where you took out a loan. With an increase in price your collateralization ratio can increase, and it becomes easier to pay down debt with the extra value your assets are worth or you can take out a bigger loan if you see fit.
As you can see Decentralized finance has some useful applications. These contracts are easy to set up, and to manage, and you can take out loans on assets you hold. As soon as you take the loan out you can use it for whatever you see fit. You can trade it for other assets or even buy a new dining room table if thats what you want to do.
Hopefully you enjoyed this brief article. If you want to create a CDP head over to oasis.app and click the borrow tab. Also always be aware of phishing attempts.