The whole concept is usually very simple when taking out a vehicle loan or a mortgage, borrowers receive funding from lenders in exchange for returns on their deposits. Borrowers or loan takers are happy to pay interest on the funds they borrow in return for easy access to a lump sum of cash. Traditionally, a financial entity, such as a bank or a peer2peer loan, facilitates lending and borrowing. When it comes to short-term loans and investing, the money market is the field that specializes in it. Multiple instruments, such as CDs, Treasury Bills, and others, are available on the money market.
Lending and borrowing in cryptocurrencies can be achieved through DeFi protocols like AAVE or COMPOUND, or through CeFi companies like BlockFi or CELSIUS.
Centralized banking, also known as CeFi, functions in a similar manner to banks. This is also why these businesses are often referred to as crypto banks. For eg, BlockFi takes custody of stored assets and loans them out to financial investors such as market makers and hedge funds, as well as other network consumers. While the centralized loan model performs well, it suffers from the same issues as centralized crypto exchanges, including the loss of consumer funds due to hacking or other forms of neglect.
DeFi lending helps consumers to become lenders or creditors in a fully autonomous, permission less fashion while also retaining full ownership of their coins. Smart contracts run on decentralized blockchains, mainly Ethereum, underpin DeFi lending. This is also why, unlike CeFi lending, DeFi lending is open to everyone without the need to provide personal information or trust someone else with your funds.
In DeFi, there are two primary lending protocols: AAVE and COMPOUND. Both protocols operate by producing money markers for unique tokens such as ETH, stablecoins such as DAI and USDC, and other tokens such as Connection. Users who wish to become lenders contribute tokens to a certain money exchange and begin earning interest on their tokens based on their existing supply APY. The supply tokens are submitted to a smart contract, where they can be borrowed from other users. The smart contract issues other tokens in return for supply tokens, which represent the supply tokens plus interest. These tokens are referred to as C Tokens in COMPUND and A Tokens in AAVE, and they can be exchanged for the underlying token.
It's also worth noting that in DeFi, almost all of the loans are now over collateralized. This means that if a consumer wishes to borrow money, they must have tokens as collateral worth more than the amount of money they wish to borrow.
When a user borrows money, the amount lent must always be less than the value of their collateral multiplied by the collateral factor. There is no limit on how long a person can borrow funds if this condition holds. If the value of the collateral falls below the necessary collateral level, the user's collateral would be liquidated so that the protocol will refund the borough.
The ratio of supplied and lent tokens in the specific markets specifies the interest that lenders earn and the interest that borrowers must pay. The interest that borrowers pay is the interest that lenders receive. As a result, the borrow APY in this sector is higher than the supply APY. The APYs (annual percentage yields) on interest are determined per Ethereum block. DeFi lending offers flexible interest rates that can vary significantly based on the lending and borrowing demand for specific tokens, as calculated by APY per block.
One of the most significant distinctions between compound and AAVE is seen here. Although both protocols provide variable supply and borrow APYs, AAVE also offers a secure borrow APY that is fixed in the short term but can adapt over time to account for shifts in the supply-demand ratio between tokens. AAVE also provides flash loans, which allow consumers to borrow funds for a very brief amount of time with no upfront collateral. The collateral factor of the supplied properties determines the sum that can be poured. There's also a smart contract that examines all of the collateral in a user's account and determines how much can be borrowed legally without being liquidated right away.
COMPOUND uses its own pricing feed, which pulls quotes from many extremely liquid markets, to assess the value of collateral. AAVE, on the other hand, relies on CHAINLINK and uses their own price feed when necessary. When a user wishes to redeem the loan and release their equity, they must then repay the right interest on their lent money. The amount of interest that has accrued is calculated by the borrow APY, which increases immediately. Each Ethereum block is a new opportunity.
While DeFi lending has many of the risks associated with centralized financing, it also has its own set of risks, including the ever-present smart contract risks, as well as rapidly evolving APYs.
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