In theory and the overwhelming narrative surrounding DeFi Lending is that it is decentralized, distributed, autonomous and trustless...and this is a good thing, maybe a great thing. But what does it really mean?
To start #decentralized is suppose to mean that no one person or group of persons is in charge.
Then #distributed means there is no one central location where you have to go, locations are everywhere, and in theory any place on earth which has internet access can access lending.
Then you have #autonomous, which implies that the software of the platform works without oversight and without interference. This quality is so important that once a DeFi lending platform is launched some of them are unchangeable. That’s obviously extreme, and most have a form of distributed governance which allows some changes.
Lastly we have #trustless, which means you don’t have to trust one person or group of persons to truthfully and honestly carry out transactions without cheating. So there you have it, and some of you are saying, okay these are the tenets of a decentralized blockchain. How does this apply to lending. Read on....
The main thematic element of DeFi Lending, as I see it, is that any person on earth, regardless of their country of origin, religion, political leanings can borrow money or receive a loan, as long as they have assets to pledge, which fit the requirements of the software program running the lending platform.
This feature is thought to eliminate many of banking rules, which are thought to favor the rich and hinder the poor. In theory a poor person, with ten Ethereum, can borrow the stablecoin Dai just as easily as a rich person, with ten Ethereum, and get the same terms or treatment from the lending entity.
So the exciting narrative behind DeFi is that it is a great equalizer. Poor smart people are given the chance to compete on an equal footing, with rich people. Which I think is partially true, as main determinant is the need for capitol.
I usually remember this by thinking that all factories and most businesses sell products, regardless whether they are products like bread, chickens or auto parts. Plus all service industries like barbers sell a service, which is their product. And banks and DeFi Lending platforms provide loans as a product.
A loan from the DeFi /lending platform is secured by your pledge of an Asset like Ethereum. The Ether is given to the DeFi Lender, to be held until you payoff the loan. It is held for you in a virtual box called a #Vault. This process of loaning you a stablecoin like Dai, which holding your Ethereum is called #Collareralization. You can apply for a loan or CDP after you deposit collateral, and in accordance with the collateralization ratio.
Thus you get a loan, called a CDP after depositing collateral.
So you are only allowed to borrow a percentage of the deposited assets value. For example, if you deposit 100$ worth of Ethereum, you will only be able to borrow 40% of its value or 40$ in stablecoins. This percentage you are allowed to borrow is called the Collateralization Ration. Now it’s very important to know, that instead of this being expressed as loan value over asset value, it is represented as asset value over loan value. So if the platform says the borrowing limit is a Collateralization ratio of 2:1, and you deposit 100$ worth of Ethereum, you must borrow less then 1/2 the value or less then 50$.
This is where it gets tricky, you can borrow less then 49$, 40$ and your asset to loan ratio will increase, that’s okay. But you can’t borrow more because your asset to loan ratio will decrease. You asset to loan ratio must be 2:1 or higher! It can not be lower. We will revisit this below.
Let’s do the math to be clear:
You Deposit 100$ Worth of Ether
Collateralization ration limit is 2:1
100/2 = 50
So 2:1 is 100 to 50
You have to borrow a sum where the lowest ration of asset to loan is 2:1.
So you can borrow up to 49.99 , but not over, to keep your ratio greater then 100 to 50 or greater then 2:1
You deposit 1500$ worth of Ether
Collateralization ration is 2:1
1500/2 = 750
So 2:1 is 1500 to 750
So you can borrow up to 749.99, but not over to keep your ratio greater then 1500:50 or 2:1.
This is a good time to discuss the concept of default. #Default normally means you failed yo make loan payments on your loan. But in DeFi Lending there are no monthly loan payments. You payoff your loan plus interest all at once, whenever you want your collateral back. Second, in DeFi lending there is interest on your Loan or CDP, but it’s not called interest, it’s called a Stability Fee. Now let’s revisit #Default. When you borrow against your collateral, the deposited asset, like Ether, you borrow against the value on the date of the loan start date or CDP start date. As you can see if your one Ether is worth $100 dollars you can borrow up to 49$. Then your collateralization ration is greater then 2:1. But if the value of Ether should fall to less then 100$, say to 80$, now you can’t borrow more then 40$, only 39$. So if Ether fell in price to 80$. Your loan of 49$ would not be 2:1 or greater. Because 49$ is less the 1/2 of 100, but it’s not less then 1/2 of 80$. So your asset to loan ratio is no longer 2:1 or greater, it is less then 2:1, so you are in DeFault. If you are in default you must deposit more asset, like Ether to push your ratio back above 2:1 or the Lending platform will sell off your Ether to payback your loan, until your asset to loan ratio is greater then 2:1.
This tricky to think about because it’s the opposite of legacy banking where you have a loan to asset ratio which is a fraction or decimal.In DeFi it’s a whole number, and you think about keeping your ratio at greater then 2:1.
So if price is very important, you can guess that a DeFi lending platform needs to monitor asset prices closely and your right. DeFi uses a entity or service called an Oracle to watch prices closely and send this price data to the DeFi lender software. In this way the DeFi software always knows what the asset price is and what your collateralization ratio is.
As you know from watching Bitcoin’s price, cryptocurrency prices are volatile, as in they go up and down. And as you can then predict your collateralization ratio is the same, but if the price changes the amount of acceptable maximal loan changes. So a DeFi lender must stay on top of this.
So if you have read this far, you are beginning to put this all together. You find a DeFi Lender who accepts you asset, be it Bitcoin, Ethereum, Binance Coin, Tron, etc and you deposit in a vault, calculate your maximal loan and decide how much of that maximum you want to borrow and borrow a stablecoin like Dai, USDT, USDJ or some similar stablecoin.You then get to benefit from your asset appreciating while you still have money to spend on other investments, the same investment or to pay for everyday expenses. Plus you haven’t sold your cryptocurrency, which equals a taxable event in most countries.
So you have been introduced to the concept of Collateralized Debt Products, a loan you automatically receive if you have the right collateral. You have been introduced to the reasons why it’s popular and provides more opportunities for people who aren’t rich. You also see how there are no credit checks, no application review, no loan application decline for various reasons. You have been introduced to basic terminology and the very important concepts of collateralization ratio, stability fee and default. Welcome to the world of DeFi, there is still much to learn, but this is a good starting point.
I came for the crypto and I stayed for the Community.
Shortsegments has been writing on the Leofinance Crypyocurrency and Financial Blog since its beginning on the Steemit platform as Steemleo.
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