The fast-evolving nature of blockchain has allowed stakeholders to capitalize on the technology in numerous ways. One of the popular innovations in the blockchain space is decentralized finance (DeFi).
In a nutshell, DeFi refers to financial applications in the cryptoverse that aim to dismantle traditional intermediaries. For example, in traditional financial systems, banks act as an intermediary and a trust mechanism between parties to ensure a fair transaction.
In DeFi, banks and other conventional middlemen are nonexistent. Instead, holders facilitate the transactions directly with each other through software such as blockchain-enabled smart contracts. According to DeFi Pulse, an analytics and rankings hub, DeFi projects are worth around $77 billion.
One of the emerging aspects of this already novel technology is DeFi loan, a form of peer-to-peer (P2P) lending via decentralized applications (DApps).
How DeFi Loans work
Cryptos stored in your wallet are not earning any interest. But what if you can lend your cryptos to someone while accruing passive income? That’s how DeFi loans work.
DeFi allows any crypto holder to lend their digital currencies to others without a third party. Lenders use a smart contract to pool their cryptos and distribute them to borrowers. The smart contract bears the rules of the loan and these may vary depending on the pool. The smart contract then issues native tokens to the lender.
These tokens are collateralized, which means a borrower needs to provide a guarantee before taking out a loan. The collateral, which comes in the form of cryptos, usually must be worth more than the value of the loan. DeFi loans are gaining popularity because they allow holders to gain passive income from cryptos sitting idly in their wallets.
Traditional Loans VS DeFi Loans
It is easier to borrow via DeFi than traditional loans as the former does not require any credit scores or background checks that the latter does.
In traditional loans, banks are the lenders. But in DeFi loans, any individual with cryptos in their wallet can be the lender.
Traditional loans typically require physical assets like a house or a car as collateral. In DeFi loans, collaterals are in the form of cryptos.
In traditional loans, interbank market affects interest rates, whereas in DeFi loans, the interest comes in the form of tokens and is based on the protocol written in the smart contract.
What Makes DeFi Loans Popular
DeFi loans are an attractive option for alternative investors who have an appetite for high risks. Here are some of the benefits of DeFi loans.
Speed: DeFi loans are processed instantly since they do not require credit scores, physical collaterals, or background checks. The loan amount is automatically available once the loan is approved. Additionally, transactions are updated in real-time.
Transparency and immutability: Since DeFi loans are all based on a blockchain, stakeholders can easily verify if the transactions are legitimate. Users can see the network activity as every transaction on a blockchain is broadcast to the network.
Dynamic interests: The interest rates on DeFi loans are determined based on the ratio of loaned and borrowed tokens in a given market. Market demands influence the rate, thereby paving the way for a more democratic lending space.
Inclusivity: DeFi allows any person that has a crypto wallet to access its services. They do not need any broker or middleman to facilitate the transaction on their behalf.
Open source: Many protocols that support DeFi are open source, meaning anybody can view and audit them. This enables developers to connect different DeFi applications and build new products and services without permission.
Risks of DeFi Loans
Hackers: Like traditional finance, DeFi is also susceptible to hacking. In August 2021, white hat hackers stole $610 million from PolyNetwork, a DeFi platform.
No customer protection: The lack of an intermediary may be a double-edged sword. When things go south, investors are not covered by bailouts and other state-backed protection often offered in traditional finance.
High collaterals: Most DeFi loans require collateral that is equal to the value of the loan itself. In some cases, the value should be even more.
Private key risks: A private key is needed to secure your wallet. If lost, you run the risk of losing your funds forever.