In terms of traditional and cryptocurrency finance, lending and borrowing refers to the act of one party giving money assets, such as fiat or digital currencies, to another in exchange for a consistent income stream. Therefore, how does Defi lending work?
The idea of "lending and borrowing" has existed for a very long time and is one of the foundational elements of any financial system, particularly the "fractional banking" configuration that is currently employed most frequently around the world. The concept is very simple: Lenders give money to borrowers in exchange for a certain interest rate, and that's really all there is to it. Additionally, traditionally, financial institutions like banks or independent organizations like peer-to-peer lenders would support such transactions.
Lending and borrowing can be enabled in the context of cryptocurrencies through one of two main channels: a centralized financial institution like BlockFi, Celsius, etc., or through the usage of decentralized financial protocols like Aave, Maker, and so on.
Decentralized lending and borrowing are made possible by DeFi protocols, ensuring that each user always has full control over their money. The use of smart contracts on open blockchain platforms like Ethereum makes this possible. In contrast to CeFi, DeFi systems don't require users to give their personal information to a centralized authority in order to utilize them.
A person uses a smart contract to transmit the tokens they want to lend into a "money market," which subsequently generates interest in the platform's native currency.
Users who want to act as "lenders" using DeFi protocols like Aave and Maker must deposit their tokens into a "money market" in order to do so. This is accomplished by a user putting their assets to a smart contract, which acts as an automated digital middleman. As a result, the coins are then made accessible for borrowing by other users.
The aforementioned smart contract distributes interest tokens to the user automatically that can be redeemed for their underlying assets at a later time. The tokens that are created are exclusive to the platform; for instance, interest tokens in Aave are known as aTokens, while on Maker they are known as Dai.
It basically implies that customers who want to borrow money are forced to give a guarantee — in the form of cryptocurrency — that is worth more than the loan itself. Nearly all of the loans that are provided using the native tokens are over-collateralized.
DeFi borrowing makes sense for a variety of reasons, despite the fact that it may appear nonsensical on paper given that the person could theoretically just sell their assets to get the money in the first place.
First off, users might require money to pay for any unplanned bills they might have had but don't want to sell their holdings because they might be poised to appreciate in value in the future. Similar to how people may evade or postpone paying capital gains taxes on their digital tokens by borrowing via DeFi protocols. Finally, people can use the money they borrow through these platforms to enhance the leverage on particular trading positions. Basically, this is how DeFi lending works.
