The possibility of using blockchain technology in the development of financial applications has improved with the introduction of DeFi. Decentralized Finance, or DeFi, has recently gained a lot of attention since it has raised huge amounts of capital for numerous businesses.

You might be amazed by the fact that about $20.46 billion is currently locked in DeFi protocols, indicating a sharp increase in demand for DeFi applications. Naturally, this has spiked the idea of DeFi lending and borrowing.

In this blog, let’s have a look at DeFi lending and borrowing.

Concept of DeFi lending and borrowing

Two basic elements on which any financial organization work includes both lending and borrowing. Most people face a situation where they have to borrow money at some point in their lives, whether it be for college loans, a home, or a car.

The entire lending and borrowing process is really straightforward. Borrowers get funds from lenders, usually referred to as depositors, in exchange for a percentage of their deposits. Borrowers are generally known as loan takers. In exchange for receiving a lump sum payment immediately, they are prepared to pay interest on the amount they get.

Traditionally, financial institutions like banks offer lending and borrowing services. However, they are under the control of centralized systems run by government authorities and gatekeepers. Due to this, regular customers are required to interact with a lot of intermediaries to get their funds.

And DeFi challenges this centralized financial sector by removing the need for any third party.

DeFi lending and borrowing give customers ultimate control over their money while allowing them to become lenders or borrowers in a totally decentralized and seamless way. It is built on open blockchains called “smart contracts,” the most popular of which being is Ethereum.

While it is common knowledge that Crypto assets fluctuate, holding them idly in wallets will not generate money. In such a situation, DeFi enters the scene.

DeFi loans allow you to earn money by lending borrowers your Crypto assets. Anybody could be a lender now, thanks to DeFi. As a result, you can lend your funds to others and generate revenue from the loan.

Smart contracts enable investors to gather their Crypto assets and distribute them to borrowers. There are numerous methods available for distributing the funds. Therefore, it is advised to conduct your own research to determine the best type of investing. Due to the wide variety of easily accessible alternatives, the same is true for borrowers.

When applying for a loan from a typical financial institution, you need collateral that can act as security for the loan you require. The decentralized ecosystem offers the same. The primary difference is that the system is anonymous and does not use any tangible property as collateral.

The fact that any digital asset can be used as collateral should not be ignored. For example, if a user wants to borrow one BTC, he must deposit the cost of one BTC in LTC.

There are two terms related to DeFi lending and borrowing that you should learn about. They are described below:

Asset Collateralization in DeFi

Asset Collateralization is a core concept in DeFi, where the borrower guarantees an asset that the lender can recover their capital in case the borrower is incapable of repaying the loan. The liquidity pool requires some form of security or collateral whenever a user borrows assets from it. If the user fails to pay back the debt owed to the pool, the lending protocol will not repay the collateral to the borrower; instead, it uses the assets to pay back the debt owed to the pool.

Asset Overcollateralization in DeFi

Asset Overcollaterization is another core concept of DeFi. What happens here is that on the DeFi platform, the borrower is required to deposit a Crypto asset with a higher percentage value than the value of the assets borrowed. Borrowers should only leverage asset overcollateralized loans if the final investment increases in value more quickly than the debt’s interest rate. The borrower might be unable to repay the loan, which would cause the borrower to become insolvent if the value of the collateralized asset drops below the total debt price.

Pros and cons of DeFi lending and borrowing

PROS

• DeFi borrowing and lending are more efficient at disbursing loans.
• DeFi protocols have better transparency as they are open-source in nature.
• No one’s permission is required to apply for a loan.
• There is no requirement for KYC procedures and data sharing.
• DeFi is anonymous and totally decentralized.
• This is a fantastic way to use your Crypto assets to generate passive income.
• Borrowers must overcollateralize to guard against unexpected price drops.

CONS

• Smart contracts are susceptible to malicious attacks that look to take advantage of programming errors.
• Due to worries about money laundering, governments might not be in favor of no-KYC lending and borrowing.
• Law enforcement agencies around the world may be concerned about anonymity.

Final thoughts: Future of DeFi lending and borrowing

The previous few years have seen phenomenal growth in DeFi lending and borrowing. 2023 will bring new challenges, but there are also many great opportunities. As more investors engage in cutting-edge financial technologies, several initiatives based on DeFi are gaining traction.