As Decentralized Finance expands, we have seen more opportunities for users of new financial instruments to take out stablecoin loans using their crypto tokens as collateral.
This might not seem like much but comes in handy when a project that has already raised funds is looking for additional capital to further develop its products. As the cryptocurrency space grows, the DeFi lending sector is also scaling up to answer the increasing demand for decentralized products, as well as meeting the expanding spectrum of borrowers’ needs.
In this article, we’ll review the criteria a project can use to choose a lending platform. We will also cover the steps that users need to follow to take out a stablecoin loan.
How to choose the right platform?
Choosing a platform for a stablecoin loan, the borrower should take into account several parameters:
• Interest rates.
• Blockchain assortment.
• Loan duration (limited vs unlimited).
• LVR (the ratio of stablecoins-to-collateral that determines the amount of the available loan).
• Security (smart contract audits).
Interest rates and LVR are quite self-explanatory. However, the blockchain assortment and lending duration are less so for inexperienced players.
As a rule of thumb, the more blockchains the borrower can access through a lending platform, the better their chances to save money on transactions.
Also, if the lending period can be unlimited, borrowers will not have an obligation to pay back the loan within a concrete period, and the platform can accrue interest almost indefinitely.
Security pertains to the architecture of a smart contract and the level of protection of the money locked in it.
Before taking a loan from a platform, a borrower should conduct some due diligence with respect to smart contract audits and make sure that their target platform is vetted by respectable third parties.
More popular platforms often prove themselves safer due to the amount of real-world testing they have undergone. However, this is never completely true as ongoing testing and audits cannot guarantee that a vulnerability will not arise in the protocol in the future.
How to take out a stablecoin loan?
Unlike a traditional credit line, the first thing a project should have to take out a stablecoin loan is collateral. Normally, the lending platform has a list (often short) of tokens eligible for collateral, i.e. whitelisted assets. Often, these are well-known assets that have a high trading value, adequate price feeds, and known volatility.
To take out a loan, the user needs to lock their desired amount of tokens on the platform. In exchange for them, the platform will give the borrower a certain amount of non-transferrable tokens that will reflect the value of their collateral.
Let us, for the sake of example, call this token $XYZ, with every $XYZ equaling 1 USD. So, if a user, for example, locks $1000 worth of Ethereum, with an LVR of 50%, they will receive 500 $XYZ for their assets.
When the borrower is ready to take out a loan, they will be able to exchange their $XYZ for any of the available stablecoins. They will be able to exchange $XYZ for stablecoins at a 1:1 ratio. However, borrowers should bear in mind that loans accrue interest, which reduces the credit they have on the platform.
Conversely, repaying the loan frees up collateral and increases their credit, allowing a borrower to continue taking out loans. In case the borrower's credit runs out completely, the borrower will permanently lose its collateral. This creates an incentive for borrowers to repay and, therefore, increases the health of the protocol.
The next steps for the industry
The ability to take out a loan becomes crucial when a project needs to improve its product and scale up their efforts. Stablecoin loans sourced via decentralized platforms are a great opportunity for cryptocurrency projects, as they eliminate middlemen that often don’t know or trust the blockchain industry.
Currently, only a small number of assets are accepted as collateral on major decentralized lending platforms like Bancor and AAVE. This is because big lending platforms do not think it’s worthwhile to build the infrastructure to include some lesser-known altcoins in their list of assets that can be collateralized. However, the ever-growing demand for loans makes the need for wider adoption of the less established altcoins hard to ignore.
The inability to offer their native token as collateral is yet a large pitfall for many projects. As an industry, we need to concentrate on making DeFi accessible for everyone, not just a few projects and holders of currencies that have already succeeded at a top-50 level.
The ultimate goal of this industry, after all, is the democratization of finance, isn’t it?