Decentralized finance (DeFi) not only facilitates anonymous crypto trading, but also offers a multitude of services.
One of the most commonly used is crypto and stablecoin lending.
Technically, it’s called “borrowing,” and it effectively allows you to obtain liquidity without necessarily having to sell your assets. It also enables the implementation of leverage strategies (i.e., opening leveraged positions), hedging, and optimizing the yield of your portfolio.
How Lending Works in DeFi
Borrowing in DeFi operates in a completely different manner compared to traditional bank loans.
First of all, there are neither intermediaries nor controls, and no issues of reliability or solvency. Everything is managed by decentralized smart contracts on blockchain (usually Ethereum), and is based on the principle of over-collateralization.
In fact, loans in DeFi almost always need to be over-collateralized.
In other words, to borrow an amount, one must lock up tokens of greater value as collateral in the smart contract than the amount requested (typically 150% or 200% or more).
Thus, not only can loans be obtained by using one’s crypto as collateral, but it is also necessary to lock up more than what is received.
For example, by locking up 1 ETH (valued at approximately $3,000), you can borrow between 1,500 USDC and 2,000 USDC.
This is because, in reality, the loan is not issued by the smart contract or the blockchain, but by lenders who do so for personal gain (i.e., to earn a return through the interest applied to the loan). Over-collateralization serves to protect these lenders, because if the value of the collateral drops too much, the system automatically sells it through so-called “liquidations”.
The important thing, however, is that you can recover the entire collateral at any time, as long as you avoid forced liquidation, by paying the due interest and fully repaying the loan received.
How to Take a Loan in DeFi
Borrowing stablecoins or crypto in DeFi is actually straightforward, but it requires caution due to certain risks that can easily be encountered (such as the risk of being liquidated).
The most popular and secure DeFi protocol for borrowing stablecoins or crypto is Aave. This brief guide will focus on the procedure for taking loans on this protocol.
First, you need to have a crypto wallet, such as MetaMask, WalletConnect, or Ledger, containing enough tokens to lock the collateral, as described above, and to pay the fees (typically ETH).
The second step is to open the DeFi lending protocol app and connect the wallet. This process is often very easy and quick, and doesn’t even require the payment of fees.
The third step is already more critical, as it involves the actual deposit of collateral.
Within the protocol app, you need to select the deposit option (by clicking on “Supply,” “Dashboard,” or similar links). Then, you must select the asset you wish to deposit as collateral and enter the amount.
At that point, you need to click to confirm the deposit: this will automatically generate a transfer request to your wallet, which must be manually confirmed. The deposit will only be executed if the transaction is manually confirmed, and only if there are sufficient funds to cover the fees and to send the tokens of the selected asset as collateral to the protocol’s app.
The fourth and final step is the actual loan application.
In the dashboard, navigate to the “Assets to Borrow” table and select the asset you wish to borrow. Loans can be obtained in stablecoins such as USDC, USDT, or DAI, as well as in crypto like ETH. However, generally not all cryptos and stablecoins are available.
At that point, it is sufficient to enter the requested amount, choose the type of interest rate to pay (variable, which fluctuates with demand, or stable, which is fixed), and confirm the transaction. The funds are immediately sent to your wallet.
It is worth reiterating that the maximum loanable amount can be approximately two-thirds of the value of the assets immobilized as collateral, precisely due to the aforementioned over-collateralization.
The Risks
The first risk is potentially linked to the choice of a variable rate.
Anyone who takes out loans in DeFi must pay interest, precisely because those who provide them expect to earn something for issuing them (otherwise no one would issue them).
If one opts for a stable interest rate, the only risk faced is that of being forcibly liquidated if the interest is not paid. However, if one opts for a variable rate, there is also the risk that it may increase over time.
At this moment, for example, the variable rate for USDC on Aave is approximately 4.7% per annum and quite stable, while for USDT it rises to 5.1% with greater variability. For ETH, however, it drops to 2.0%, but with volatility.
The second risk, as already mentioned, is related to the forced liquidation of the collateral. In this case, the smart contract automatically, and in an unstoppable and irrevocable manner, enforces the forced sale of the collateral to fully extinguish the loan. The user, in that case, can keep the borrowed funds forever, as the loan is considered settled after the liquidation, but they will never be able to retrieve the collateral that was locked as security.
In this case, the main issue is the volatility of the collateral’s market value. Referring back to the previous example, if 1 ETH is used as collateral to borrow 2,000 USDC, it only takes the price of Ethereum to drop to $2,000 for the smart contract to immediately and irrevocably enforce the forced liquidation of the collateral.
It is also worth noting that if the interest is not paid, the same thing happens because the smart contract automatically sends it to the lenders. The transfer is made regardless, even if the borrower decides not to pay, and in that case, the smart contract would be forced to liquidate part of the collateral to send the interest to the lenders.
The third risk is the closure of the protocol. Protocols like ave are considered very secure, but theoretically not entirely risk-free. Other protocols, however, can be much less secure.
The final risk is related to fees. In fact, these vary, so when it comes time to repay the loan and recover the collateral, or to pay the interest, there is always the risk of having to pay higher fees.
Leveraging
Leveraging deserves a special mention, which is the practice of opening long or short positions on the price of an asset by borrowing funds.
Leveraging also exists in traditional finance, and its basic functioning is the same in DeFi, albeit with the differences highlighted above.
This way, one can amplify their long or short positions, increasing both potential profits and potential risks, with the primary risk always being liquidation.
For example, if you are long on an asset (like ETH), the goal of leveraging is to borrow funds to buy even more.
The most commonly used leveraging strategies are Looping on Lending Protocols, which involves depositing volatile collateral to borrow stablecoins for investing in long or short positions, or Leveraged Tokens or Perpetual Longs, which allow the use of DEX with perpetual futures with leverage up to 20x.
For long positions in particular, there is also Delta-Neutral with Yield Enhancement, which allows balancing long positions with short hedging to minimize risks while generating yield from staking or points farming. For short positions, there are Options and Volatility Selling, which enable the use of crypto options to short volatility, or carry strategies in highly volatile markets.
