DeFi Mini Course: Part 3, Lending and Borrowing
Before You Get Started on Part 3.
In this part, you'll learn how to lending and borrowing works on COMPOUND or AAVE, and lend out some USDC for yourself.
Disclaimer: Crypto is still in its infancy and very high risk. I recommend setting the expectation that you will lose all of the money you invest as you're learning and treat it as an education. Throughout the mini-course, I will indicate the cryptos I hold myself, so at least - if you do copy me - I'll lose money if you do! This course is not investing advice, it is intended to teach you how DeFi works! You are reading these materials and taking any guided steps at your own risk. Crypto is technical and funds are easily lost if you are not careful with passwords as well as sending and receiving money to/from the right wallet addresses - not to mind bugs in nascent software platforms or bad actors. Learn with small amounts to minimise your risk.
Update June 2021: Disclaimer and Workaround for High Gas Costs.
Given the high transaction costs on Ethereum, it may be wise to learn instead on Binance Smart Chain or Celo - two blockchains I have used. The lending and borring platforms I have used on each are Venus.finance and app.moola.market , respectively.
Part 3, Lending and Borrowing
DeFi is like a bank, but you can participate in being the bank :)
When you borrow from a bank, there is collateral involved. If you borrow for a house, you promise them the house to secure the loan. Same if you borrow for a car.
As far as I know, you can't yet borrow for a house or for a car on DeFi. Right now, you can only borrow to buy a different crypto, e.g. you can borrow Ether , but you have to offer some other crypto as collateral, say Bitcoin.
Now, this might seem pointless for day to day life and... It largely is! Bear with me...
The current reasons for borrowing and lending are - primarily - for financial engineering. I'm going to cover these financial examples because I want to provide a sense of the full range of DeFi services to further my point that DeFi is like a bank, but you can be served by the bank or being part of the bank yourself... for better or worse!
Borrowing on a DeFi platform
Let's look at a hypothetical example where you start with 10 Ether, each Ether worth 1,000 USDC:
Grandad Mick goes to a DeFi lending platform (like Aave or Compound) and uses his Ether to borrow USDC. Using 10 Ether as collateral (together worth 10,000 USDC), the platform allows Mick to borrow 8,000 USDC (80% of your collateral). They won't allow Mick to borrow the full amount of his collateral, just as most banks won't allow you to buy a house without a deposit - unless it's 2008...
You take that 8,000 USDC and you buy 8 more Ether. Now you have 18 Ether in total.
Let's say Ether doubles to a price of 2,000 USDC - so you know have 36,000 USDC worth of Ether. Grandad Mick is in good shape! He pays back his loan of 8,000 USDC (plus interest - which we'll ignore for now) and now has 28,000 USDC (or 14 Ether) - a tidy profit of 4 Ether.
Now, let's look at the downside scenario. Let's say that Ether priced in USDC drops by just 10% down to 900 USDC per Ether. Mick's collateral of 10 Ether is now worth only 9,000 USDC, and his lending limit (80% of collateral) is now only 7,200 USDC - which is now less than your loan of 8,000 USDC. Here's what happens next - and I'll use the AAVE example.
The Aave protocol now allows great-aunt Mary - sitting over there in the armchair - to swoop in and repay up to 50% of borrowed amount (at the new cheaper price) and get a 5% bonus from Mick! She repays 50% of the borrowed 8,000 USDC = 4,000 USDC for 4.44 Ether (4,000 / 900), plus gets a bonus of 0.22 Ether - for a tidy packet of 4.66 Ether. Fair play to you great aunt Mary!
Off of 10 Ether of initial collateral, Mick has now lost 4.66 Ether - pretty harsh for a 10% drop in the price of Ether per USDC. Ouch!
So, what's happening here? Basically, the platform (Aave) is making it highly punitive for borrowers to go below their borrowing limit and incentivising them to have a lot of collateral behind their borrowings in case prices fall. This mechanism is designed to make it safer for lenders to lend, but it's not entirely safe!
Sudden and large price movements
Let's say Ether drops to 200 USDC. Mary can now repay 50% of Mick's borrowed 8,000 USDC for 40 Ether - but there isn't 40 Ether of collateral for her to take - there is only 10!!! There is insufficient collateral backing borrowings!
What happens next depends on the lending platform. Some platforms - like Aave - use a governance token to provide reserves, or partial reserves, against this kind of a scenario. Depending on the severity of price movements, those reserves may or may not be enough to save the day. Ultimately, if there is not enough collateral or reserves, it's the lenders that lose out - that's the risk they are getting paid for.
So now that you see one of the risks of lending (and remember there is always smart contract risk as well - the risk that the code makes a mistake) - let's try out some lending.
*Lending on a DeFi Platform
*Navigate to https://app.aave.com/deposit or to https://app.compound.finance/ and connect with your MetaMask wallet. Note that you can use Aave with a Coinbase wallet - Aave's documentation is also more clear.
*Select USDC (USD Coin) and then deposit/supply $10 of USDC.
*You'll be prompted to select your transaction speed (duration). If gas fees are very high ($20+), you may wish to come back another time and hope they are lower. Yes, gas is very expensive right now.
*You'll now start to earn interest on the USDC that you have supplied. (On Aave, you'll be given aUSDC in return, on COMPOUND you'll receive cUSDC).
One last question then...
How are interest rates set?
As a concrete example. Let's consider that there are lenders lending 100 Ether and borrowers borrowing 50 Ether. That ratio - of borrowing to lending - is called the Utilisation Factor.
The platform (Aave or Compound) puts together an algorithm that aims to increase the Utilisation factor to a certain level (a level that is different for each crypto). They do that with an interest rate curve that pays more interest as the utilisation increases - which encourages more lenders to come onto the platform. Here is an borrow rate curve for USDC and USDT - both US dollar stablecoins:
One last point on interest rates - you'll see that borrowing rates are always higher than lending rates. Check out the comparison for yourself here: https://app.aave.com/markets .
The reason for this is the Utilisation Factor being less than one, i.e. only a portion of assets loaned to the platform are borrowed out by borrowers - and the interest paid by borrowers is shared out among all lenders to the platform (regardless of whether none, part or all of their lendings to the platform are being used by borrowers).
Almost done with Part 3 on Lending Platforms!
So, with DeFi, where there is a service (e.g. currency exchange or borrowing), there is also a complementary earning opportunity (e.g. providing liquidity to exchanges or lending). These earning strategies are also known as farming or yield farming.
Taking this a level further, you can imagine a platform that splits money between different earning strategies - somewhat like what a hedge fund does in traditional finance. That's what harvest.finance and yearn.finance do - and we'll cover those in Part 4.
First, take a look at the quiz below before moving on to Part 4.
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Once you've clicked Submit on the quiz, scroll up to see your answers!