Decentralised Finance Explained: Borrow, Lend Cryptocurrency Without Banks

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Cryptocurrency has become investors' favourite digital asset. Data from crypto analytics firm Chainalysis revealed that about 20 million Indians have jumped on to the crypto bandwagon in 2021.

With more and more investors rallying to book profits, newer concepts have emerged in the crypto space.

The decentralised finance (DeFi) sector, in particular, has seen astounding growth recently. In early 2019, there was only $275 million of crypto collateral locked in the DeFi economy. It eventually hit $4 billion by July 2020 before reaching $14 billion in 2021, according to Chainalysis.

“DeFi is one of the most exciting areas of the wider cryptocurrency ecosystem, presenting huge opportunities to entrepreneurs and cryptocurrency users alike,” the report said.

But, what is DeFi and why should you care? Here we explain.

But First, the Blockchain

Cryptocurrency, non-fungible tokens (NFTs), web3, metaverse and Decentralised Finance (DeFi) are all fueled by blockchain technology.

For the uninitiated, blockchain technology is a digitally distributed, decentralised, public ledger that exists across a network. Put simply, it is like your bank passbook, where all the transactions are recorded on a ledger. However, unlike your passbook, these transactions can be seen by anyone.

Decoding DeFi

“Necessity is the mother of invention," this phrase is applicable in the case of DeFi as well. Prior to its existence, it was impossible for investors to borrow, and lend their crypto assets. Imagine, you visit a bank and ask for a loan not to buy a car or a property, but to buy Bitcoin or Ethereum or any other cryptocurrency. Your application is most likely to be rejected.

Decentralised finance has been touted as a solution to lowering the barrier of entry for those who struggle to access bank accounts.

DeFi runs on a public blockchain, such as Ethereum. So, there is no single inventor. These products don't use any third parties for facilitating crypto lending and borrowing. On DeFi, trades are made without the need of any broker.

Additionally, DeFi is an open protocol, meaning that you only need a crypto wallet to use the platform. You don't need any identity documents to create an account on DeFi. It is way simpler than having a bank account.

Funds can be transferred instantaneously via a blockchain, so there is no waiting and absolutely no down-time. The transaction rates (for now, at least) are much better than at traditional banks, though transaction costs vary depending on the blockchain network.

Lending, Borrowing Made Easier

If you own any cryptocurrency and you want to earn interest or rewards for holding the asset you can lend your money to a DeFi. The interest rates are much higher than any traditional banks.

Borrowing digital assets (Ethereum, Bitcoin, Dogecoin, etc.) to make a trade is easy and automated. Unlike banks you don’t have to fill forms and get scrutinised based on your credit score. A computer bot does it all for you.

However, most DeFi ask for collateral and use over-collateralisation, meaning you must have more (in crypto assets) than the amount you want to borrow; if the asset's value falls too much, the protocol may take your collateral to avoid losses.

DeFi users can also earn cryptocurrencies through something called "yield farming," in which they lock up their crypto assets to get rewards. Rates vary depending on protocol and asset, skilled yield farmers move their assets to capitalise on the best rates.

What Are Smart Contracts?

Smart contracts is an agreement between two parties, in this case, the DeFi platform and say the borrower. It is essentially, a computer signed agreement which is uploaded on a blockchain distributed database, meaning that it is of public view and cannot be edited or modified.

In simple words, there is no need for any third party or a broker to process your loan. And the peer-to-peer transaction is closed only when the conditions in the agreement are met.

For instance, say if you want to borrow 1 Bitcoin from a DeFi platform. You apply for a loan, mention the tenure and submit a collateral. Following this, an agreement is signed between the lender and borrower which is automated.

So, after the tenure period is over, the transaction happens immediately, making the whole process digital, transparent and secure.

Stablecoin in DeFi

Mainstream cryptocurrencies such as Bitcoin, Ethereum, and Dogecoin, are susceptible to market volatility, which means their prices fluctuate almost every other day, making them unstable.

Stablecoins make it easy for DeFi platforms to lend loans, because as their name suggests it is stable and subject to less volatility. They are specifically engineered so that their price is more stable. Some popular DeFi stable coins are DAI, USDT and USDC.

In the DeFi space, volatility makes borrowing and lending difficult and creates stability issues for protocols. So, stablecoins, make borrowing, lending, trading easier and without volatility. They will be a core part of your DeFi journey.

Risks

DeFi have been the target of cybercriminals since their existence. In a recent report, research firm Chainalysis revealed that scammers mooched off over $14 billion worth of cryptocurrency from victims in 2021, up by 79 percent from $7.8 billion in 2020.

Due to the open nature of DeFi, any tech savvy individual can exploit vulnerabilities in the code and run away with huge sums of money. However, to reduce the risks of exploits, DeFi projects now commission audit firms to review their code and help them patch any issues found.

(Ankitt Gaur, CEO, and Anshul Dhir, COO, are co-founders of EasyFi Network, a DeFi lending protocol built for public blockchains. This is an opinion piece and the views expressed are the authors' own. The Quint neither endorses nor is responsible for them.)