Lecture 4.1.0. DeFi Lending Concept of Operation
The concept of operation of DeFi lending is somewhat different from CeFi lending. DeFi lending involves the followings five features:
(1). Lending Platform
This is a digital platform that creates a liquidity pool for lending and borrowing, and therefore, provides security for digital transactions so that the lender and the borrower do not cheat each other.
However, unlike CeFi lending, in DeFi lending the cryptos are not deposited on the central exchange but in pools created on a blockchain.
(2). Lender
You are a lender when you give out your cryptocurrency for the lending service. All you do to become a lender is to look for a lending platform and deposit your cryptocurrency. That involves clicking just one or more buttons and your cryptos are deposited for lending into a liquidity pool created by the lending platform protocol.
(3). Liquidity Pool
This is where lenders deposit their cryptos. Liquidity pools are created by the lending platform protocol.
What exactly is a liquidity pool?
You can view a liquidity pool as a central account where lenders can deposit their cryptocurrencies and borrowers can then withdraw some of this deposited crypto as a loan.
Since there are different cryptos, it means a liquidity pool is specific for a particular crypto. For example, an Ethereum pool will only accept Ethereum as deposit while a Bitcoin pool will accept only Bitcoin. Meaning that you cannot deposit Ethereum into a Bitcoin Pool.
The liquidity pool is created on a blockchain, which means there is no central authority that has control over the deposited cryptos. Because they are on a blockchain, the lender is totally in control of his deposited cryptos.
Since a lender supplies his cryptos to a liquidity pool, thus, making funds available for lending, he is called a Liquidity Provider (LP).
Liquidity refers to the ease with which an asset can be converted into ready cash; therefore, cash is the most liquid of assets. By adding his crypto to the pool, a lender increases the liquidity of the digital assets in the pool.
(4). Interest as Reward
For supplying his crypto to a liquidity pool for lending, the lender is entitled to receive interests as reward for every transaction that involves his deposited. The interests are paid in crypto tokens.
There are three main types of tokens that may be given out to a lender as rewards for supplying liquidity:
(a). Native Token
This is the token for daily transactions within and outside the lending platform protocol.
(b). Governance Token
This is the token that gives the lender a voting power. For instance, a holder of such token can propose changes to the protocol, debate and vote whether to implement changes suggested by others, choosing which cryptocurrencies to add support for, adjusting collateralization factors, and making changes to how tokens are distributed.
In some protocols a native token also acts as a governance token.
(c). Stake Token
This token is the one that represents the individual’s stake in the pool.
When you deposit your cryptos into a pool as a lender, you will receive the number of stake tokens commensurate with the amount of cryptos you have deposited in the pool. Anytime you want to withdraw (redeem) your deposited crypto, you will use your stake tokens to exchange for your deposited crypto.
Over time, the exchange rate of these stake tokens to the underlying deposited asset increases, which means at the time of withdrawal of your fund, you actually receive more cryptos than what you initially put in.
In addition, some lending platforms can give you some native tokens and governance tokens as incentives to make you to continue to keep your crypto in the liquidity pool as a lender.
Hence, imagine receiving these three types of tokens – native, governance, and stake tokens – just by supplying liquidity as a lender! This is one reason why DeFi lending is a good source of passive income.
(5). Borrower
This is the investor who will borrow for his personal purpose the deposited crypto of the lender from the liquidity pool. For an individual to successfully borrow a cryptocurrency, he will need collateral.
How much a borrower can borrow against his collateral is referred to as the loan-to-value (LTV) ratio, and it varies among protocols, but usually ranges from 50 to 75%. That is, you may not be able to borrow more than 50 to 75% of your collateral value.
Once the borrowed crypto has been repaid, the collateral is returned to the owner (the borrower).
The collateral can easily be sold (liquidated) to pay up a loan in the case the borrower couldn’t pay back the loan or the value of the collateral has depreciated below the threshold level. The Loan Threshold is the minimum amount of collateral that is required for a crypto loan.
When the price value of your collateral is approaching the loan threshold, the protocol will automatically alert you to either add more assets to your collateral or risk part of the collateral being sold off to bring it back to the threshold limit.