DeFi has been the buzzword in the crypto industry for months now. In the aftermath of the black Thursday crash in March, which saw Bitcoin crashing below 4000 USD, many DeFi applications successfully launched their main nets, which drew a lot of attention to the emerging space. DeFi related tokens like Compound’s COMP, Aave’s LEND, Balancer’s BAL or Synthetix’s SNX have since yielded astronomic gains for investors. But what exactly is DeFi and how do DeFi protocols work? Learn about it in our new six-part blogpost series “Demystifying DeFi”. New articles coming daily! Today we will cover decentralized borrowing & lending platforms, which have experienced strong growth so far in 2020.
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After the rise of decentralized exchanges (see part 2 of our blogpost series), lending and borrowing applications started to take center stage in the evolution of the DeFi sector. In comparison to the relatively simple concept of decentralized exchanges, everything gets much more complex when looking at trustless lending & borrowing protocols.
One important element that was introduced to the DeFi world are stablecoins, which in many cases (e.g. Maker) are a key component of the protocol. FIAT-pegged stablecoins (e.g. DAI on Maker) are used to settle transactions on-chain.
Other key elements of blockchain-based lending protocols include borrowing and lending rates, as well as collateralization rate requirements to on the one hand attract liquidity to the protocol and on the other hand ensure the security and stability of the platform.
There are various ways how these above-mentioned rates can be defined. The most prominent approach (e.g. followed by Maker and Compound) is the introduction of a governance model to the protocol. The idea behind these governance models is to replace the trusted central party (e.g. the bank) who in a more traditional context would be the authority defining lending and borrowing rates as well as the required collateralization ratio, by a decentralized decision-making process. For that reason, protocols like Maker and Compound have introduced protocol-specific governance tokens which give their holders certain voting rights, essentially placing the power to define the above-mentioned rates in the hands of the protocol’s user community.
A common critique of such token-based governance models is that in many cases (e.g. early stages of Maker) a relatively large part of the governance token supply is held by the developers (or foundations) that created the protocol. This obviously contradicts the idea of decentralization as a large part and in some cases even the majority of governance tokens being held by a single entity, gives such an entity the power to control the decision-making process of the protocol, therefore making it a practically centralized platform.
Another important point to be taken into account when looking at lending & borrowing platforms is the collateralization ratio required by these protocols. Currently, those collateralization rates range anywhere from about 150% to 750% (because they are operating in a highly volatile environment). This means that the loan amount is lower than the value of the collateral a user locks into the collateral vault of the protocol. As mentioned earlier, this is primarily meant to secure the protocols from large-scale liquidation events triggered by violent market downturns and increased market volatility. In that regard, DeFi applications differ from traditional centralized financial service providers, who are able to offer much lower collateralization ratios.
This brings us to the question of what assets are eligible to be used as collateral in these lending & borrowing protocols. For one, this depends on the design of the protocol. But as the vast majority of DeFi protocols are running on the Ethereum blockchain, most DeFi applications are limited to Ethereum-based assets such as its native cryptocurrency (Ether) or tokens built upon the Ethereum blockchain using the ERC20 standard (ERC20 Tokens).
Taking into account Bitcoin’s role as king of cryptocurrencies with a market cap of almost 200 billion USD and its subsequent dominance of approx. 57% of total cryptocurrency market cap, it becomes obvious how much capital is restricted from being used in DeFi applications because of the lack of interoperability between different blockchain networks. To tackle this issue and unlock the vast amounts of capital bound in Bitcoin to be used within the DeFi ecosystem, projects like WBTC and REN have emerged, which allow for collateral-eligible tokens mirroring the value of Bitcoin as an ERC20 token to be minted. Currently, the amount of BTC locked in DeFi protocols amounts to approx. 500 million USD. Amid its market cap of approximately 200 billion USD, this equals a mere 0.5% of BTC supply. This number alone gives an impressive indication on how much growth potential still exists in the DeFi sector, especially as cross-chain interoperability is on the rise.
Stay tuned tomorrow for part four of our DeFi series and learn about the concept of yield farming!