Lending

From Traditional Loans to DeFi

Loans represent a particular type of credit vehicle, where the lender (or creditor) lends to the borrower (or debtor) the lent item (usually a currency or other very liquid assets) in exchange for the eventual redemption of the valuation or principal sum.

The concept of loans also recognizes, with a few moral or social exceptions, the economic basis for lending activity as a business model, defined by the extra interest and other borrowing costs added to the principal value.

As such, every new institutional loan has three main defining characteristics, which are:

  • The Interest Rate

It represents the "cost of credit" and all the other costs associated with the lending operation and means the lender’s fee for using their capital. The rates can be fixed (an unchanging percentage applicable to the outstanding debt) or variable (usually based on a standard market rate, representing the rate at which credit institutions borrow money from the market or the central bank).

  • The Lending Default Risk

Creditors may expect the debtor to pledge an asset called collateral to protect themselves from the risk of a debtor's failure or inability to pay.

  • The Term

The term represents the time interval between credit time and the expected time to complete the principal’s repayment, accrued interest, and any other fees necessary. The type of debt can range in duration, from under a year for commercial credit to over 30 years for mortgages. The longer the term, the higher the interest rate.

Right from time, lending has grown to reflect the current technological progress and societal changes. Notable innovations include the credit cards launched in the '50s, the widespread of ATMs in the '70s, and online banking pioneered in 1985 by Quicken Loans in Detroit and refined throughout the '90s. Even though new lending products improved and diversified the range of benefits they offer to the borrower, they failed to address the creditor's centralized nature, which proved to be a structural weakness and a design limitation on the lending industry's potentials. However, the widespread use of the internet allowed for "peer-to-peer" lending to be pioneered in 2006 by Prospa. The advent of blockchain technology spearheaded the full potential of decentralized lending. This was popularized by the seminal Bitcoin whitepaper in 2008 and made possible by other subsequent innovations, especially by the launch of the Ethereum network in 2015, which introduced programmable and executable "smart contracts". Blockchain technology provided an infrastructure allowing for complex and trustless financial operations, collectively known as DeFi.

The DeFi space reunites traditional banking services provided in a decentralized manner on a blockchain infrastructure. This includes savings and checking accounts, loans, asset trading, insurance, and many more. DeFi is currently seen as one of the essential and fastest-growing applications in the cryptocurrency space, with 2020 being a critical turning point, marking a ten-fold rise in Total Value Locked (TVL) user wallet addresses. At the time of writing, DeFi represents a $24 billion TVL industry with over 1 million user addresses. It also means the highest traffic source on the Ethereum network, with 7 out of the top 10 Ethereum Dapps (daily volume) being DeFi applications.

Within the DeFi industry, the top five trends that dominated application growth during 2020 and that will continue to guide the market in 021 are:

Liquidity Mining

Liquidity Mining (or yield farming) is an incentivization scheme that encourages crypto asset holders to provide liquidity by locking their tokens in smart contracts and receive a high Annual Percentage Yield (APY). The model was popularized in June 2020 when a lending platform, Compound, launched the COMP Governance token. The DeFi sector quickly adopted the improved governance token approach.

Zaps

As some of the Liquidity Mining platforms still have a complex and tech-savvy-oriented UX, a growing trend is to create user-friendly interfaces, called Zaps. Zaps provide a user-friendly experience that only requires simple steps (such as depositing the ETH), and the rest is done automatically in the background. Zaps fuel mainstream adoption.

Stablecoins

Representing the solid cornerstone of much of the DeFi industry, stablecoins are blockchain-issued tokens designed to hold a specific value, either by “pegging it” to one or more fiat (or crypto) currencies or through complex algorithms. In 2020, the supply of stablecoins increased by $20 billion and reached $26 billion by the end of the year. The healthy growth of stablecoins is very promising for the DeFi industry, and it is expected to remain like that throughout 2021. Stablecoins have gained traction as they attempt to offer the best of both worlds—the instant processing and security or privacy of payments of cryptocurrencies and the volatility-free stable valuations of fiat currencies.

DeFi Aggregators

DeFi aggregators connect DEXes to provide users with the best market rate for their trade. Namely, the DeFi industry has evolved into a complex ecosystem, where it is challenging to keep track of all the possible opportunities. Besides providing the best trading opportunities, the DeFi aggregators also improve liquidity across multiple decentralized networks.

Flash Loans

Flash Loans are the most critical advancement in the DeFi industry marking this paper’s focal point. Flash lending is a financial operation in which a user borrows funds and repays them (including the interest rate) instantaneously, without providing any collateral. Flash loan is made possible by being processed entirely within the same blockchain transaction. If the borrower fails to repay the loan principal (including the interest) within the transaction execution cycle, the transaction is reverted.