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How Does Defi Lending Work?


Traditionally, lending is how banks and other financial institutions make much of their money. They give out loans to businesses in form of overdrafts and other credit facilities to earn an interest calculated in annual percentage yield or APY. Some interests are also paid in annual percentage return or APR. The annual percentage yield is an adjusted interest rate for compound interest, and it is calculated using the formula, (1+R/N)N-1. The APR or annual percentage yield is an amount of money that is charged per year on the amount of money borrowed as a loan. APR is the interest rate on the amount borrowed plus the fees stated as an annual percentage of the amount loaned. It gives a more accurate estimation of the true cost of a loan, and it is higher than the state of the interest rate where there are fees associated with the loan. The APR is calculated using the formula F+Interest/Principal/number of days* 365*100. It gives you the percentage paid for your principal monthly. The difference between APY and APR is that APY is compounded, while APR is not. In decentralize, finance APY and APR are used to calculate the amount an investor will get on an investment after a given period. You will often see the figures in yield farms and the higher the APR or APY, the more money you will get from investing in a pool. We will discuss DeFi lending of crypto assets, DeFi loans, lending pools, DeFi protocols, DeFi borrowing, and other crucial concepts in this article. The goal is to explain DeFi overall, talk about decentralized exchanges, how crypto holders can earn, and the building blocks of any decentralized finance protocol. Irrespective of your background and overall interest in DeFi you will find this article helpful as we will discuss some of the fundamental concepts in detail.

What is DeFi Lending?

Before we talk about the complete mechanics of DeFi lending, let's understand the simple set of of any lending system. Lending is a part of traditional financial services and the complete setting is powered by interactions between the lender and the borrowers. Lenders have a spare sums of money or crypto assets which they do not want to use immediately, while borrowers need these funds for business or other purposes. To settle this batter-type problem, developers of DeFi smart contracts allow lenders to receive interest for keeping their funds with the lending platforms while earning an interest rate passively. Borrowers who need the funds can in turn get funds from these platforms and pay interest to the lending platform. The difference between the lending amount and the borrowing interest rate is what the platform takes a fee, while the return for lenders is calculated using the APR and APY formula described earlier.

Borrowers on the other hand DeFi lending is some of the most important elements of a decentralized system. Lending in cryptocurrency is accessible through DeFi protocols like AAVE or Compound or CeFi companies like BlockFi or Celcius. With CeFi or centralized finance protocols, lending and borrowing work like it in banks. Centralized finance

companies are therefore referred to as crypto banks. BlockFi, for example, takes the money deposited on their platform and borrows the money out to institutional players or hedge funds, or to other users of their platform. Decentralized lending models for DeFi loans are more innovative but they are not risk-free. There have been cases of bad loans, hacking, rug pools, or other insider exploitations. CeFi models also go against an important ideal of decentralization which is giving owners self-custody of their assets. DeFi lending, however, allows users to become lenders or borrowers in a decentralized and permissioned way permission way that gives them complete control over their crypto assets. It is based on an underlying code that runs on open blockchains such as Ethereum and EOS. Lending and borrowing on DeFi are also accessible to everyone without a need to provide personal details or trust anyone else to hold their fund.

Decentralized Finance

AAVE and compound are examples of DeFi lending protocols that work by creating money markets for particular tokens like ETH, stable coins like DAI and USDC, or other tokens like Link or wrapped BTC. Users who want to become lenders supply their tokens to particular money markets on the platforms and start receiving interest according to the supply APY. The supply tokens are sent to a smart contract to be available for other users to borrow. In exchange for supply tokens, the underlying code issue other tokens that represent the supply tokens from these platforms plus the interest on their deposits. These tokens are called cTokens on Compound finance, and aTokens on AAVE, and holders can redeem them for the underlying tokens.

In DeFi at the moment, all loans are overcollateralized which means that the user who decides to borrow funds must supply tokens in the form of collateral that is with more than the loan token. The reason why borrowers take these loans, even though they have more than enough funds is diverse. Sometimes, these borrowers do not want to sell their tokens but need funds to cover unexpected expenses. Other reasons why holders of these tokens may not want to sell their collateral tokens include avoiding or delaying capital gain taxes, or not being willing to close a trading position that could possibly result in profit. The amount that can be borrowed depends on two factors. The first factor is the number of funds available in a particular market, although the available funds are hardly a problem in active markets. The second factor is the collateral factor which is calculated based on the volatility of the token in question. Stablecoins, for example, allow users to borrow up to 75% of the supplied tokens because they have a relatively stable value.

If a user decides to borrow funds, the value of the borrowed amount must stay lower than the value of the collateral multiplied by the collateral factor. In as much as the value of the amount borrowed is less than the collateral multiplied by the collateral factor, there is no limit of how long a user can borrow funds. If the value of the collateral falls below the required collateral level, the user's collateral will be liquidated. The interest paid by borrowers is the interest lenders earn, which makes the borrowed APY higher than the supply APY in a lending market. Interest APYs are calculated per Ethereum block, and calculating APY per block means that DeFi lending provides variable interest rates depending on the lending and borrowing demands. AAVE and Compound are different because they offer variable supply and borrow APYs, although AAVE also offers stable APY and flashloans which we shall talk about later in this article. Stable APY is also variable in the short term, but it is fixed in the long term.

An example of a DeFi lending scenario can be better understood when we look at an existing DeFi protocol. Let's look at Compound Finance to understand borrowing and DeFi lending of digital assets. When a user deposits funds to Compound finance, the user is issued cTokens that are equivalent to the deposited amount. These cTokens will be required to reclaim the underlying ETH at the due date. The exchange rate between cTokens and the underlying ETH is calculated using a stable APY of 0.02%. The issued cToken accumulates interest with each Ethereum block even though it is transferred to another wallet. The rate of the interest accrued by the cToken is determined by the ratio of the supply/borrowed capital. Assuming that in our example, the exchange rate of cETH which is our cToken, to ETH increases by 0.0000000003 with each block. If the rate of increase is constant for a month, we can solve for the interest that can be made during that period. If we have 5 blocks solved on the Ethereum blockchain every minute. We can solve for the supply APY using 0.0000000003*4*60*24*30, which we can add to the previous exchange rate to get a new rate of 0.02005184 which is higher than than the previous exchange rate. If a user decides to redeem an initial deposit of 10 ETH, for example, they would have earned an interest of 500*0.02005184 or 0.2592 ETH in interest as a percentage return for their ETH. The original amount of cETH does not change but the change in the exchange rate resulted in the interest earned. Just as interest is accumulated with every single block on Compound, the same amount in interest is also accumulated with every block on AAVE. Although on AAVE, the value of aTokens is begged to the value of the underlying tokens at a 1:1 ratio. What that means is that if you deposited a 50 ETH on AAVE, you will receive 50 aETH, equivalent to the current market value of the underlying ETH. AAVE distributes the interests earned to aToken holders on their wallets. A holder of these tokens can redirect the interest to another address. Borrowers lock their aTokens as collateral and they cannot redeem the underlying assets when they are being borrowed on AAVE. The amount that can be borrowed on AAVE is determined by the collateral factor of the supplied assets. There are also codes on these protocols that check the collateral on users' account to calculate how much can be borrowed without immediate liquidation. AAVE sometimes uses the price-feed of the Chainlink price oracle and comes its own if that is needed. When a user decides to redeem their collateral, they also have to pay the accrued interests on the assets they borrowed. The accrued interest is determined by the borrowed APY, and it goes up automatically with each Ethereum block. DeFi lending is risky because the program can be hacked. We will now look at code to understand what smart contracts are, which are the building blocks of DeFi.

Understanding Smart Contracts

DeFi lending platforms are built with a smart contract. A smart contract works like a contract in the real world, but they are digital. It is a piece of code that executes without centralized control on the blockchain. With a smart contract, we can build agreements and collaboration systems without the need to trust third parties. A simple instance of a smart contract will be a crowdfunding platform like Kickstarter that allows users to raise funds. If these users reach or exceed a target, they receive the funding for their projects. If they don't the fundraising will be canceled and the fund goes back to the contributors. Such a process is completely automated and as soon as fundraising is started, the contributions will be recorded in a distributed ledger on the blockchain automatically. When the target is reached, the funds will be sent to the account of the fundraisers. Such a setup which looks much like if and else statements are the underlying logic of a smart contract. Smart contracts are immutable and distributed, which makes tampering with a smart contract quite difficult. Smart contracts can be applied to a lot of use cases and in the case of DeFi lending, the usefulness is priceless. The syntax of these contracts resembles Javascript with some modifications. It is the logic behind most blockchain and decentralized finance protocols. We will now talk about decentralized loans.

What Are DeFi Loans?

Lending Pools

How do DeFi loans or crypto loans work? How are they different from traditional lending? To understand how DeFi loans work, we will take a look at crypto lending again in more depth this time. Decentralized loans allow you to borrow thousands or millions of dollars without waiting for approval. Centralized loans have made it hard for a lot of serious entrepreneurs to get funding for their businesses. The financial institutions request for credit score and other personally identifiable information to guarantee that you will pay the amount given to you as a loan. With decentralized loans, the set up is different because it runs on the blockchain. DeFi loans or decentralized loans can be collateralized like the example given before with AAVE or compound, while another class of loans known as flash loans requires no collateral. Maker DAO, for example, allows you to take a loan against your deposited collateral. The loan issued on Maker DAO is 2/3 or 66% of your initial collateral deposit. When repaying your loan and the interest, you will receive your Ethereum deposit to your connected cryptocurrency wallet. The principal is often paid in the DAI stable coin while the interest is paid using the governance token or Maker. Maker is the governance token that is used to make important decisions on the Maker DAO ecosystem. When there are fewer borrowers on the Maker DAO tokens the DAO reduces the interest rate. The interest rate is increased when there is a surplus of borrowers, and when there are lots of unpaid loans, the interest rate is adjusted up to encourage repayment and reduce loan requests.

Flash loans are the game-changer in DeFi loans. With flash loans, you can borrow a huge amount of money without requiring a social security number, a credit score, or collateral. You simply have to return your funds in one block transaction. You may be wondering how you can use a loan that you must return in the same transaction. The perfect case for this is Arbitrage which is simply buying cryptocurrency from one exchange and selling it on another. Platforms like AAVE allow you to borrow funds for this process. Keep in mind that a borrower who defaults will pay the interest due on the loan amount. The entire process involves good lending decisions on the part of the lender and excellent borrowing decisions on the side of the borrower. Technically, the programmer has to create a bot to spot the price differences because they are fleeting and may disappear before you can take advantage of them manually.

What Are Crypto Assets?

Crypto assets can be NFTs, tokenized assets, or crypto tokens. The format is highly varied today because of the implementations of multiple instances and use cases on the biggest decentralized application blockchains. So we may now describe a crypto asset as an in-game asset in the metaverse development or a simple collectible on a decentralized platform like The most important point to consider is that crypto-assets are not issued by traditional banks and they can include a crypto loan taken by a cryptocurrency trader who intends to earn interest. Such a trader can lend assets and earn interest on a lending protocol. Although it is easy to think about it otherwise, borrowing assets is also a way to hold cryptocurrency assets. So asset borrowers and lenders are owners of cryptocurrency assets and DeFi market participants. Lending in crypto is permissionless DeFi lending, and DeFi borrowing also involves cryptocurrency assets.

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Overview of Decentralized Finance Activities

Decentralized Finance

Decentralized finance activities leverage blockchain technology and the ability to pay interest rates on borrowed funds or financial instruments. Since you understand how a DeFi loan work already, you can think about decentralized finance activities as something bigger. It is so because there are a bunch of activities that we have not considered yet in DeFi here. Think about an entire financial system of decentralized applications. The most essential requirement for users is a simple crypto wallet with an internet connection and they can build an entirely passive income stream from simply investing in DeFi. Yield farming, liquidity mining, staking are the common language in the DeFi space. DeFi applications are designed by DeFi development company, having sophisticated algorithms secured by maths, enabling users to earn sometimes beyond their collateral value with a simple loan. The strategies for this may be pretty advanced and definitely involves some serious programming and maths. A physical property can also be tokenized and sold on the blockchain. The underlying value of the loan possible with blockchain-based fintech applications or DeFi financial applications is huge. The risk factors will also go down as the DeFi space moves towards mainstream adoption. In a metaverse scenario, locking crypto assets which can be tokenized on the blockchain to obtain loans will be possible. The most innovative protocols will see the highest lending growth rate. The use of a Centralized exchange is also popular today because a lot of people feel DeFi is too complex. That is far from the truth, as DeFi is truly for everyone.

Lending Pools

Lending Pools

Lending pools are a collection of assets provided by lenders on decentralized blockchain platforms to earn interest. The underlying code of these platforms makes these funds available for borrowers who take these funds and return these funds to the platform with an interest. The borrowers are mostly traders who anticipate an increase in the price of the tokens they borrow as well as a rise in the price of their collateral. They therefore do not want to sell their collateral but need the borrowed asset at the same time. There are also those who hold to avoid certain tax regimes.

Rejolut Can Help You Build A DeFi Lending Platform

At Rejolut, we are masters in how DeFi lending work. Our in-house developers have years of experience working with the interconnected software stack that forms the backbone of DeFi lending. We are committed specialists in DeFi application programming languages for multiple blockchains. As an award-winning platform with experience working on the same protocols as the biggest lenders in DeFi with large long-term investors, we bring project ideas into reality. Your DeFi application does not have to be like what everyone else is doing. The total value locked can range from small to large and you can add extra friendly functionalities to increase usage.

Concluding Thoughts

At this point, you understand what APR and APY mean, along with DeFi lending and the example of how the DeFi lending setup works. DeFi is a fast-evolving space and it is gradually becoming the norm as generation Z and Millenials are already tired of the exclusive-style investment of baby boomers. In a world of change and innovation, we may see more application of DeFi lending ideas. There might be a combination of multiple features of existing platforms or entirely new ideas created by innovative minds. The best thing about blockchain technology is that it brings about the highest level of inclusion. Flash loans have made a lot of people millionaires while NFTs have set artists free. There is still more to come in this upcoming space of the blockchain. If you are building your next DeFi project, reaching out to us at Rejolut, can make all the difference. We hope that you now understand DeFi a bit more and you are ready to thrive in a new financial world.

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In the end there are a variety of options Defi companies pay for their investors’ yield, and not only by “yield farming”. It is a financial platform that is based on blockchains with public access which is most notably Ethereum. The tokens of Defi generate interest and let you take out loans, borrow money, purchase insurance, or trade as a crypto-speculative investment.

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