Over the past few years, the awareness and use of cryptocurrencies and Decentralized Finance (DeFi) has been growing exponentially and in particular, DeFi lending protocols are gaining tremendous traction. Their independence of central authorities combined with attractive interest rates directed intrigued investors to the likes of Aave, Compound, or Fulcrum. Through these platforms, they can lend their tokens allowing them to earn significantly higher returns. But what is DeFi lending, stablecoins and interest payments all about?
A key metric to consider when looking at the DeFi space and its general health is the Total Value Locked (TVL), which quantifies the value of assets that are being supplied and provided (resp. locked-up) in smart contracts of specific protocols. As of today according to DefiLlama, more than $ 200bn are locked in DeFi protocols, thereof ca. 50% of it on the Ethereum Blockchain.
What is DeFi Lending?
While the purpose of DeFi lending, similar to regular lending using traditional banks, is the provision of liquidity for those willing to pay a premium (the interest), the way it works noticeably differs.
Lending and borrowing takes place entirely autonomously and protocols govern these processes by protocols in decentralized networks without any humans intervention. These protocols do not require you to undergo a credit scoring or provide further identification or financial record. Given that you have the necessary funds available in your wallet to collateralize the loan, you are good to go. Lending protocols are especially attractive in bullish markets, where the borrowers expect to make a higher return than the interest to be paid back to the lenders in addition to the principal of the loan, of course.
Instead of an intermediary institution that handles the process of collecting and distributing capital, smart contracts functions execute once certain criteria are met. Also, as with all DeFi applications, bear in mind that when using fully automated and decentralized lending protocols like Aave or Compound, you are the only one responsible for storing your assets and keeping them safe, the platforms do neither take custody nor liability for any of it.
So how does it work? Every new block, lent assets accumulate interest, while borrowed assets are charged interest. The lion’s share of the interest paid is returned to the asset pool and a small part is kept aside as protocol reserves, serving as a cushion in the event of oracle failures or major liquidations in a short period (that might lead to increased slippage). As the lender who provided liquidity receives a share in the pool, its value increases through the interest paid by the borrowers. The risk on the lenders’ site is that in certain rare circumstances the money can’t be withdrawn directly from the pool, e.g., when there is a specific lack of liquidity. This is similar in the traditional finance, when there is a bank run that (luckily) also happens very rarely.
When it comes to collateralization, pretty much all loans are overcollateralized. The relevant figure in that case is the collateral factor which varies from asset to asset and can be seen as a measure of the risk involved. For example on Aave, one of the biggest lending markets, if you want to borrow DAI you need to provide another token which can be used as collateral (e.g., ETH). For each DAI you borrow, you need to provide 133% of the value in the collateral’s token as the Loan-to-Value (LTV) of DAI is 75%.
If the collateral’s value depreciates and the liquidation threshold falls short of, the collateral gets liquidated to repay the borrowed sum and has a penalty added on top to incentivize appropriate behavior. The liquidation threshold is slightly higher than the collateral factor, ensuring that the borrower’s sum can be fully repaid in spite of slippage or rapidly declining prices (kind of a safety margin).
As long as the threshold is maintained (on Aave the concept is called “health factor”), also taking into account the due interest payments, there is no limit as to how long funds can be borrowed. However, the interest rate is in many cases variable and depends on supply and demand of liquidity. Aave offers a stable rate as well that is – due to the lower volatility risk involved – is much higher than the variable rate (and by the way, also not fully guaranteed).
Furthermore, the new concept of flash loans was pioneered by lending protocols. In this innovative approach, the need for a collateral was waived, as the issuance and repayment of the loan itself happens within one single block on the Blockchain. This is only possible as the blocktime represents the fundamental, atomic time measurement within the ecosystem. Flash loans enabled parties, in principle, to get risk-free loans in strong contrast to the overcollateralized loans which have been (and still are) omnipresent.
The figure below depicts the mechanics of the DeFi lending process. In case you are wondering what cTokens or aTokens stand for, these are the DeFi lending platforms’ native versions of the token supplied (cToken for Compound, aToken for Aave) which are used to keep track of the funds supplied as well as any interest accrued.
For example, if you provide 1,000 DAI to Compound, you will receive 50 cDAI in return (with an illustrative exchange rate cDAI/DAI= 0.02). Several months later, when withdrawing your cDAI, you will notice they are now equivalent to 1,075.78 DAI, meaning your cDAI appreciated in value in comparison to DAI. That way, interest is being paid to the lenders through the value increase of the lending pool itself. Although Aave makes use of a slightly different, more traditional approach to pay interest, their aTokens are also at the core of every lending process.
The following snapshot shows what you can expect (“Supply APY” when you currently deposit Ethereum funds to Aave:
Although the APYs differ between the tokens, it is visible that stablecoins have rather high interest rates. Why is that?
Why do Stablecoins have rather high APYs?
Stablecoins are a major backbone of cryptocurrency trading. Prior to their emergence and increased popularity, one would have to use fiat money and other cryptocurrencies to transact with. However, since this brings along some downsides – volatility and/or slower, more expensive transaction – stablecoins pose a more apt way to trade seamlessly and boost liquidity on the markets.
This is linked to another reason why borrowers are willing to pay more interest on stablecoins, which is their stability as the name suggests. Stablecoins are oftentimes being transferred quickly between various exchanges by arbitrageurs to exploit price inefficiencies. For these kinds of strategies to work in the long run, one ideally has a “stable base” to transact with, rather than tokens that are fluctuating in value. Similar applies for decentralized apps which require stable prices to be used and transacted upon. Also, over time one could observe a steady surge in stablecoin-quoted trading pairs (xyz/USDT, xyz/USDC, xyz/BUSD etc.), a further driver of demand.
Furthermore, an aspect to bear in mind is the state of the market. Whenever you find yourself in a bullish market you will see interest rates, and hence demand, for stablecoins soar. This is because as prices rise, traders will seek to leverage their positions to maximize their gains. On the contrary, when there is a bearish market, interest rates for stablecoins drop noticeably since the general trading volume declines. In fact, during those times you can occasionally see the interest rates of volatile tokens (i.e. not stablecoins) rise as traders look to borrow and short sell them.
All the aforementioned aspects do lead to a steady and massive demand for stablecoins, and as basic economic understanding suggests, high demand leads to high prices, in this case in the form of above-average interest rates.
Final Thoughts On DeFi Lending, Stablecoins and Interest Payments
The DeFi sphere, including DeFi lending, stablecoins and interest payments, has grown substantially over the past years. DeFi lending encompasses extensive protocols with up-to-date features and distinctive characteristics (e.g., over-collateralization), and is thus growingly competing with traditional finance. A steady demand exists for the crucial stablecoins, which are some kind of glue stabilizing the entire ecosystem, rendering it more mainstream-accessible and easier to interact with. They help ensure the crypto sphere advances as a whole.