One of the main selling points of digital assets is that they provide the ability for anyone with an internet connection to access financial services without centralized gatekeepers, hence the name decentralized finance (DeFi). DeFi services, such as payments, lending, borrowing, savings, trading, and market making have captured tens of billions of dollars in active usage, with staking and lending taking the lion’s share.
Let’s take a look at how investors use DeFi to borrow and lend, and how it compares to traditional lending with fiat currency.
The decentralized nature of crypto and DeFi loans means that by default, there is no entity that underwrites contracts, utilizes credit scores, or conducts credit checks towards borrowers. Under these conditions, unsecured or undercollateralized loans are simply untenable, as the risks of loan default is high, with little legal recourse.
DeFi lending platforms issue crypto backed loans, which requires borrowers to put up collateral, such as ETH, BTC, or other crypto assets. Loans are required to be overcollateralized, which means the loan-to-value (LTV) ratio is always under 100%. The lending platform will usually require the LTV ratio to be within 40-80%, due to the volatile nature of crypto assets. If the LTV crosses a certain threshold, the platform will liquidate the collateral to make sure lenders remain whole.
For example, using ETH as collateral on AAVE can only borrow up to 82.5% of their position. If the user deposits one ETH worth $3,900, they can borrow up to 3217.5 USDC. AAVE will liquidate the ETH collateral if the LTV ratio reaches 86% of the ETH value. So if ETH drops to $3,741, AAVE will sell the 1 ETH to cover the $3217.50 loan plus interest, take a liquidation fee, and return any leftover value to the borrower.
This robust liquidation system has allowed DeFi lending protocols to flourish since inception over 4 years ago, surviving the volatile and stressful nature of crypto markets. In a market with 50-90% drawdowns, DeFi has performed better than traditional banks that required bailouts during the Great Financial Crisis. As time passes, DeFi will slowly prove that it is more resilient and robust than traditional systems.
Note that there are platforms or entities that utilize crypto to issue unsecured or undercollateralized loans, but the level of adoption pales in comparison to secured loans, due to user aversion to elevated risks.
DeFi protocols and crypto lending platforms are essentially web applications coded with smart contracts. This means they are self-executing based on their programmed functions, accessible 24 hours a day. The most popular lending applications are AAVE, Compound, and Maker.
But how do crypto loans work? Basically, a user wanting to obtain a loan would head on to the applications’ websites, connect their crypto wallet, allow the smart contract to receive funds from the wallet, deposit the funds, specify a loan amount and take it out.
If you would like to benefit from the robust lending systems DeFi offers, you must deposit tokens onto the applications’ liquidity pools to start earning interest immediately. To do so, you’ll need an Ethereum wallet such as Metamask or Rainbow Wallet. You’ll also need to fund the wallet with crypto; the easiest way to do so is by sending cryptocurrency from a centralized exchange like Coinbase to your crypto wallet.
Once funded, visit the protocol’s website and enter the dapp. From there, you can choose which pool to deposit funds to and begin earning interest. Most DeFi pools offer variable APYs, so it’s important to keep track of the yield these staking pools offer.
Protocols such as AAVE and Compound offer 4-8% yields on USD, due to their blue-chip status and non-fixed deposit nature. Another application, Pendle Finance, allows users to earn interest rates between 8-25% on their crypto holdings, depending on the base asset used.
Newer lending applications may offer higher rates by allowing lenders to earn rewards, paid in the platform's governance tokens. This tactic is known as yield farming, but it is not recommended to beginners due to the risks involved. It is generally recommended that newcomers stick to market tested DeFi applications, as these apps are more battle-tested and their risks are easier to estimate.
If new users would still like to earn higher DeFi yields passively, knowing that due diligence and risk analysis is required, they can utilize yield aggregators such as OUSD.
OUSD is a yield-generating stablecoin, backed 1:1 by other stablecoins such as USDT, USDC, and DAI. OUSD generates yield by deploying these stablecoins into DeFi yield strategies curated by the protocols’ engineers. OUSD conducts risk analysis, audits strategies, and rebalances stablecoin allocations for OUSD holders, ensuring that they get the best yields on a risk-adjusted basis.
All strategies employed are market neutral, meaning that OUSD does not take on any speculative positions that may result in large drawdowns. Since OUSD only utilizes DeFi strategies, OUSD is 100% transparent and auditable 24/7 through the blockchain. In light of recent uncertainties in regards to centralized exchanges and lending platforms, OUSD holders can be sure the protocol is fully solvent and operational.
As always, users simply hold OUSD in their wallets with no staking or lock-ups required. Yield generated is automatically sent directly to holders’ wallets, saving users transaction fees from withdrawals or claiming rewards. OUSD was the first yield generating stablecoin in DeFi, helping users make the best risk-adjusted passive income and higher interest rates with their stablecoins.
You can buy Origin Dollar (OUSD) through decentralized exchanges such as Uniswap or centralized platforms such as Kucoin or Gate, or buy directly on the OUSD app via the Origin dapp. In order to buy OUSD through the app or a decentralized exchange, you’ll need a crypto wallet. For maximum security, it’s recommended to keep inactive funds on a hardware wallet.
Flash loans are uncollateralized loans whereby a user borrows and returns funds in the same transaction. Flash loans are usually utilized when a user wants to unwind or create a leveraged position. For example, if a user owes $8000 USDC from a $10000 ETH position, and does not have $8000 USDC somewhere else, he would have to slowly withdraw the ETH and sell it back for USDC to repay the loan.
Since the loan is required to be overcollateralized, the user cannot withdraw all $10000 worth of ETH at once to repay the loan. Flash loans allow the user to repay the USDC, sell the ETH, and return the flash loan all in one transaction.
Flash loans can also be used for arbitrage opportunities.
Getting a crypto loan through DeFi is well worth it for many investors. However, if you're strapped for funds, it's probably a better idea to get a traditional loan. DeFi loans require over-collateralization, meaning that you'll need to post more funds as collateral than what you're borrowing.
These types of loans are especially useful for many types of investors. Long-term investors may want to lend out their crypto to receive an APY on their tokens, while risk-tolerant investors may post collateral to leverage their crypto positions.
What are the benefits of getting a crypto loan through DeFi?
Getting a crypto loan through DeFi offers benefits like instant access, no credit checks, and transparent terms thanks to blockchain technology. These loans are typically over-collateralized, ensuring that borrowers maintain a higher level of security.
How does over-collateralization work in DeFi loans?
Over-collateralization in DeFi loans means that borrowers must provide collateral worth more than the loan amount to mitigate the risk of default. For instance, if you borrow $1,000 worth of USDC, you might need to deposit $1,500 worth of ETH to secure the loan, ensuring that lenders are protected against market volatility.
What is the difference between DeFi loans and traditional loans?
DeFi loans differ from traditional loans in that they require over-collateralization and are facilitated by smart contracts without credit checks. Traditional loans, on the other hand, typically involve credit assessments and can be under-collateralized, with loan terms dictated by centralized financial institutions.
