The growing innovations of decentralized finance offer more investment opportunities by the day. With DeFi lending, you have yet another option to diversify your portfolio and automatically build your wealth.
In this article, we’ll discuss how DeFi lending works, what its risks and advantages are, and how you can make the most of this opportunity.
What Is DeFi Lending?
Traditional Vs. DeFi Lending
Unlike traditional lending controlled through third parties such as banks, DeFi offers lending opportunities without intermediaries. This peer-to-peer lending shifts control to the consumer by expediting the loan process and maintaining the transparency of both parties involved.
For traditional banks, on the other hand, anything above .30% can be difficult to receive these days and requires locking your money in something like a certificate of deposit for five years.
How DeFi Lending Works
Without a third party to handle the legal side of loans, smart contracts are the foundation of DeFi lending. These agreements made by two or more parties automatically enable specific programs once necessary conditions are met, and all actions are recorded on the blockchain.
Using a smart contract, you can deposit cryptocurrency with an exchange, like Vauld, as collateral and receive a fiat currency loan in return. You then pay this loan back with interest over a predetermined period, at the end of which you receive your collateral back.
Vauld users can also deposit cryptocurrency into their accounts to earn passive interest. This can be achieved through a simple savings account, or you can earn more by locking in your funds at a fixed deposit rate.
In many cases, these deposited funds are moved from your personal wallet to a centralized lending pool. From here, loans are given to borrowers while you, the lender, earn interest.
Before partnering with any exchange, however, be sure to research how they secure your funds. Since decentralized financial institutions are still not regulated, this can spell trouble if exchanges don’t have the right precautions in place against cyberthreats.
In fact, cybersecurity remains a key risk factor when investing in cryptocurrency. Let’s take a look at a few of the other risks associated with DeFi lending so you know how to better avoid them.
Risks Of DeFi Lending
One of the more unique risks associated with DeFi lending is impermanent loss, a phenomenon that can eliminate some of the coins provided by a lender.
How exactly does this work?
In liquidity pools, a pair of cryptocurrencies are balanced with each other to form a market for traders. A common pairing example in a liquidity pool is Ethereum and Dai (ETH:DAI), which provides you access to both tokens for permanent liquidity.
Contributing to a pool means depositing an equal value of both assets, regardless of how many tokens this equals for each. In exchange, you receive a percentage of the pool. But as the values of each token shift, the lending pool shifts as well.
Day traders known as arbitrageurs will take advantage of this difference and buy one of the cryptocurrencies at a discounted rate. While this helps balance the lending pool, the changed number of tokens can cause issues for users providing liquidity.
Since, as a lender, you get a percentage of the pool and not a predetermined number of tokens, receiving your funds could mean getting an unbalanced return of the once-equal crypto you deposited. In other words, this intended investment could be a financial loss.
Flash Loan Attacks
Another problem that creates obstacles for DeFi lenders is flash loan attacks. This attack takes advantage of a concept known as flash loans that allows users to borrow as much as they want without capital. The caveat? If not paid back, the loan is automatically reversed.
The main goal of a flash loan is to:
- Help lenders avoid the risk of borrowers being unable to pay back their loans
- Eliminate the need for lenders to take collateral from borrowers
Of course, this does not mean that bad actors are not figuring out new ways to manipulate the system. Flash loan attacks are among the most common threats due to the loans’ high rate of return, low cost of execution, and anonymity.
The process begins with a borrower manipulating the market while taking out the loan. When done successfully, the value of the borrowed token crashes, allowing the borrower to purchase their tokens back at the lower price and sell them for a profit on a different market.
Knowing how to manage and avoid these risks is critical for success, which we’ll address in our DeFi lending tips section shortly. But first, let’s take a look at the benefits associated with DeFi lending.
Benefits Of DeFi Lending
The first advantage of DeFi lending that we addressed briefly above is that the interest rates earned on deposits are strikingly more lucrative than rates offered by traditional banks. In fact, rates that would otherwise be well under 0.5% are closer to the double digits.
These rates positively impact everyone involved in the DeFi lending process. Not only do lenders earn more, but borrowers can take out loans at a lower competitive rate as well.
In a circumstance without DeFi loans, a crypto holder may be forced to sell their assets to make a larger purchase. With borrowing rates that fall well below what most personal loans offer, it is easier than ever to receive fiat currency in exchange for collateralized crypto.
The unchangeable nature of the blockchain has been a selling point for cryptocurrency for a long time. All transactions are publicly documented and cannot be altered or manipulated, developing a more trustworthy system for everyone’s finances.
How does this immutability benefit lenders? Every addition to the blockchain can quickly and easily be confirmed by any network user. The transparent and unchangeable aspect of this ledger ensures the legitimacy of every transaction.
Access To Analytics
Another advantage of DeFi lending over traditional options is that the digital function of DeFi sets up the perfect opportunity to monitor trends and create analysis charts.
This data is a great way for potential lenders to determine whether now is the right time to lend for ideal returns on their investment.
Now that we have a good understanding of a few DeFi lending benefits, let’s discuss some expert tips, including how to avoid risks.
DeFi Lending Tips
Start With Stablecoins
A great way to begin your DeFi lending endeavors — without encountering too much volatility — is by depositing stablecoins. Coins like Tether are backed by actual commodities, such as the U.S. dollar or gold, so interest paid out to lenders is more stable.
While lending with more volatile cryptocurrencies can be an effective way to earn more profits for seasoned investors, the ability to trade and sell while your loans are locked is severely limited.
Stablecoins also mitigate risks brought on by impermanent loss. Since these assets are backed by real-world value, the fluctuation of their worth is almost nonexistent, and they typically trade right around the $1 mark.
Choose The Right Platform
Should you decide that more volatile options like Bitcoin or Ethereum are ideal for you, here are a couple of key lending tips:
- Do not lend all of your assets. If an opportunity arises, you should have available funds to sell or trade.
- Diversify the assets you lend.
- Find the best customer-focused exchange that makes it easy to earn the maximum rates.
For example, when you lock your funds into a one-month fixed deposit at Vauld and renew the fixed deposits every time they mature, you’ll receive the maximum APY rates available for the crypto you deposit.
Choosing the right platform is also a matter of avoiding risks. With cybersecurity playing such an important role in decentralized finance and its current lack of regulations, be sure to research the exchange you partner with to verify that your assets are in good hands.
Here at Vauld, we move funds from your wallet to a centralized lending pool that’s insured for $100 million in BitGo, a leading digital asset trust and security company. This way, all of our customers’ assets are protected against possible threats.
DeFi Lending Made Easy
DeFi lending takes the traditional loan process and makes it quicker and easier, providing more opportunities for you to profit. Whether you’re lending stablecoins or collateralizing Bitcoin to borrow fiat currency at a low rate, there’s a way for you to benefit.
Plus, many of the risks of DeFi lending can be avoided simply by selecting a crypto exchange that keeps its users in mind with every decision.
At Vauld, you receive a wide variety of earning opportunities, an arsenal of security features, and quality customer service. This means you can start earning with confidence as soon as you make your first deposit.