From the beginning of 2019, DeFi products and services have become a long-term hot topic in the blockchain field. Platforms and products that provide DeFi services have also appeared one after another. Among them, decentralized lending projects have caused considerable waves in the market. DeFi considers itself to be a "new financial revolution movement" - so what is the essence of DeFi, how does decentralized lending work, what are its innovation and pain points, and where are the opportunities worth paying attention to?
What is DeFi
DeFi is the abbreviation of Decentralized Finance, also known as Open Finance. It refers to a decentralized protocol used to build an open financial system and designed to allow anyone in the world to conduct financial activities anytime, anywhere.
In the existing financial system, financial services are mainly controlled and regulated by the central system, whether it is the most basic deposit and withdrawal, or loans or derivatives transactions. DeFi hopes to establish a set of transparent, accessible, and inclusive peer-to-peer financial systems through distributed open-source protocols to minimize the risk of trust and make it easier and more convenient for participants to obtain financing.
Compared to traditional centralized financial systems, these DeFi platforms have three major advantages:
a. Individuals with asset management needs do not need to trust any intermediaries. The new trust is rebuilt on the machine and code;
b. Everyone has access rights, no one has central control;
c. All agreements are open source, so anyone can cooperate in building new financial products on the agreement and accelerate financial innovation under the network effect.
Decentralized borrowing refers to matching the borrower and lender through the decentralized borrowing agreement, and then immediately transfers the assets and completes the loan after the pledge is confirmed.
The decentralized loan agreement provides the platform with a standardized and interoperable technical foundation and plays a role in security management during the loan process. Compared with the traditional lending model, the decentralized lending model has the following characteristics:
a. Fiat currency loans combine with digital asset loans (the stable coin model can be seen as a combination of fiat currency and digital assets);
b. Mortgage based on digital assets;
c. Realize real-time transaction settlement through automation and reduce actual costs;
d. Use the over-collateralized model to replace credit checks, which also means that groups and entities that cannot use traditional services can be served.
Three modes of decentralized lending
The four most famous decentralized loan agreements are Compound, Dharma, dYdX, and MakerDAO. We can summarize them into three modes:
(1) P2P matching mode
Both Dharma and dYdX are peer-to-peer agreements that match borrowers and lenders. Therefore, the amount of loans and borrowings based on these two agreements is equal.
For example, in Dharma, a smart contract acts as a "guarantor" to assess the borrower's asset prices and risks. The creditor decides whether to lend to the borrower based on the evaluation result provided by the "guarantor". At the same time, when the borrower fails to repay on time, the "guarantor" automatically executes the liquidation procedure. The maximum loan period of the Dharma platform is 90 days, and the loan interest is fixed. During the loan period, the lender’s funds are locked and interest is only earned after matching with the borrower.
The dYdX protocol is also a P2P model, but the main difference between it and other lending platforms is that dYdX also supports transactions other than borrowing and lending, such as futures trading. When a trader opens a position in dYdX, he will borrow a deposit and agree with the lender on the terms and agreement through the platform to conduct a margin transaction. Therefore, dYdX's target customers are mainly margin dealers. The interest in the dYdX platform is variable, and users do not have a lock-up period or maximum period when making loans on dYdX.
(2) Stable currency model
The typical model of this model is MakerDAO. There are no lenders but only borrowers, and the only asset that can be borrowed is DAI. The borrower borrows the newly created DAI by collateralizing the digital asset (now ETH). DAI is a stable currency linked to the US dollar issued by the MakerDAO platform. The pledge ratio of the pledged assets and loans must be kept above 150%. The interest is global and determined by MKR holders by voting. Interest is not stable, having risen from 2.5% to 19.5% in more than a month.
(3) Liquidity transactions
Taking Compound as an example, debits and lenders trade through the liquidity trading pool instead of matching with counterparties. The interest rate of each loan and loan is determined by the liquidity of the pool, that is, the ratio between the total amount of money provided by the lender and the total amount of demand of the borrower fluctuates. Compound does not set a fixed loan term, and the lender can deposit funds into the loan pool to continuously earn interest and withdraw assets at any time. The borrower has an unlimited contract period.
The development and future of DeFi
In December 2017, with the launch of MakerDAO and the USD-linked stablecoin DAI, decentralized loans began to develop. As of December 31, 2018, nearly 97% of active loans were made through the MakerDAO agreement, of which the main users were enterprises. Compound was launched in September 2018, mainly serving small loan users. MakerDAO only supports lending DAI, so that Compound jumps to the second place immediately.
Overall, decentralized lending is the second application that DeFi has taken after cryptocurrency. Against the background of closed corporate financing channels and lack of asset circulation channels, the three models of platforms have gradually opened up the market with their respective advantages, and the scale has been emerging since the beginning of last year. But currently, most of the platforms are still more or less integrating the centralized process into their business.
The wide application of DeFi still needs a long road. But in terms of cost savings, solving trust, and reducing financial risks, we have long been optimistic about DeFi and decentralized lending.