In the early stages of the DeFi ecosystem, peer-to-peer lending and collateralized loans were both used for borrowing. Peer-to-peer lending has all but disappeared these days since it is difficult to enforce loan payback in a decentralized environment due to the limitations of central agents and reputation systems.
Investors can both lend and borrow on a decentralized app (dApp) in order to generate yield. You might be perplexed as to how earning a yield on borrowing is feasible because that would never make sense in conventional finance, but in the world of decentralized finance, (nearly) everything is possible (DeFi).
When compared to CeFi (Centralized Finance), DeFi borrowing and lending offers advancements in efficiency, accessibility, and transparency. With DeFi, anyone may become a borrower or a lender without providing personal information, proving their identity, or going through KYC (know your customer) requirements. There is a method known as "looping" that allows investors to profit from borrowed funds.
Looping Explained
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 being used mostly around the globe now.
In a simple sentence, looping is supplying an asset and borrowing against that asset. Borrowing money for a loan that is less valuable than the collateral seems insane. Simply put, this is because many crypto owners do not want to part with their most priceless possessions. They can increase liquidity without trading by lending their capital. If someone has $50,000 in ETH, for instance, but doesn't want to sell it, they can send it to a lending protocol and borrow up to 75% of that amount.
Then after the first round of successful borrowing, you can deposit the borrowed money again to get another 75% of your deposited value. And that's how the loop continues and it will be increasing your total supplies value and also your total supplied borrow. So if you're getting paid to borrow your APR increases on every loop and also if you're getting paid to supply because both are increasing in value simultaneously.
Understanding borrowing and lending in DeFi better
Users who want to serve as lenders can deposit their funds into smart contracts built using the DeFi protocol. They will receive newly created tokens in exchange. These redeemable tokens serve as a representation of the principal and interest.
The annual percentage yield (APY), or interest rate, which is defined by the ratio between provided and borrowed tokens in a particular market, includes the rate of exchange between native tokens and tokens deposited.
Those who wish to borrow money may select one of these processes and provide collateral as a supply to be able to borrow. The fact that these loans are over-collateralized is a crucial component. In other words, borrowers put up as collateral a larger sum of cryptocurrency than they borrow, just to maintain caution against unforeseen thefts.
What you are permitted to borrow has a limit. It depends on the entire amount of funds that are really accessible for borrowing from a specific market. Even though it might not be a big deal, it might come into play if someone actually tries to borrow a lot of a particular token.
Additionally, a lot depends on the "collateral factor" of the tokens that are given. This phrase describes the total amount of money that can be borrowed depending on the caliber of the offered collateral.
Risks in looping
DeFi protocols initially come with some risks, like the possibility of third-party smart contracts being altered and the possibility of borrowing APYs rapidly increasing.
There are no real risks related to DeFi lending when compared to centralized finance. DeFi, however, also carries risks, just like anything else. For instance, there are some dangers associated with smart contracts, as well as the possibility of abrupt changes in APYs.
While using DeFi platforms to lend and borrow money is generally a simple process, there are a few minor variations in how each particular protocol functions, such as the range of supported wallets, fees that may apply, etc.
Why you should loop: Advantages
- To leverage lending & borrowing
DApps present appealing chances for the risk-taking investor, nevertheless, with the application of leverage. In contrast to centralized earning platforms, lending and borrowing are both possible without a middleman.
The process is as follows: You first make a deposit on a DeFi protocol of a particular asset, say ETH. As a result, you are now able to borrow money using the deposited ETH as collateral.
- Your LTV never changes
LTV is the short form of (Loan to Value) and it states when you will get Liquidated. When looping, the LTV will never change and it opens space for borrowing much more without any or less risk.
- Getting paid to borrow
Imagine receiving a loan in USDT for 15% or more! This would also assist you in using the recursive leverage approach I mentioned earlier to achieve much higher yields.
DeFi projects' features and usability are progressing rapidly. It is the responsibility of the project developers to make it as appealing to consumers as feasible given the proliferation of other ecosystems and the escalating rivalry for TVL.
Let's look at the drawbacks of lending and borrowing on DeFi protocols.
The reason the above-mentioned technique produces absurdly high returns is that you would be heavily leveraging your principle and becoming a chad degenerate.
You might not be able to repay your loan in time if the market crashes or experiences a correction. This would be very bad because it would mean that all of your profits would be lost and your entire position would be at risk of being wiped out. Therefore, it is crucial to only take on risks that you can handle.
Conclusion
The foundation of DeFi ecosystems before is lending and borrowing procedures. Even if it is straightforward, there is still money to be made, and the options for doing so are expanding your horizon of knowledge and making use of looping.
Borrowing and lending in DeFi support a variety of beneficial activities. Without dealing with any banks or genuine counterparties, individual users can earn interest on their holdings, traders can borrow and lend actively, making the exchange markets and capital provision markets more efficient.
Also published here.