Introduction into DeFi Lending

Decentralized Finance, or “DeFi” has evolved into a network of various integrated and decentralized financial services and instruments. Several DeFi Lending platforms have become powerful financial tools in the crypto space. What are these DeFi Lending Platforms, how do they work and how do they differ from their centralized, or “CeFi” counterparts?

Simply put, DeFi Lending Protocols allow users to lend and borrow cryptocurrency without going through a centralized intermediary, completely permissionless while maintaining full custody over their assets. The beauty of DeFi is that lending is no longer reserved to banks and institutions, but anyone can become a lender and earn interest rates from borrowers, on a global scale.

Lenders deposit their digital assets into “liquidity pools”, which then become funds that the protocol lends out to borrowers. Much like in a traditional bank, lenders earn interest on their deposit while borrowers pay interest on their borrowed funds.

Interest rates for lenders and borrowers are typically variable and are determined by utilization of the deposit amount. Interest rates can vary among DeFi platforms. The entire lending process is executed without intermediaries (decentralized), based purely on smart contracts (i.e. programmatically).

CeFi platforms

On the other hand, CeFi platforms like BlockFi and recently bankcrupt Celsius, are also called “Crypto Banks” as they function very similar to the traditional bank model. They take custody of the deposited assets and lend them out to institutional players such as market makers or hedge funds, or other users.

Some CeFi lenders even invest the deposits into other risky crypto projects and liquidity pools. The CeFi model is susceptible to losing customers’ deposits by being hacked or other form of negligence (e.g., bad loans, management fraud, mismanagement of funds, insider job, etc.) and they all go against the value proposition of blockchain tech, where users maintain full custody of their assets.

DeFi Lending Platforms typically provide loans that are fully collateralized, which means that users who wish to borrow funds must first deposit some digital assets (aka collateral: ETH, etc.). So, a user who deposits 10 ETH worth $15,000 can then borrow $5,000 worth of another asset like DAI. If they do not pay back the loan ($5K DAI), their collateral is reduced.