How do cryptocurrency lending and borrowing apps work?

How do cryptocurrency lending and borrowing apps work?

One of the important core features of Decentralized Finance (DeFi) is cryptocurrency lending and borrowing app, which allows depositors to earn interest on their crypto savings or borrow against them. The cited use case for taking out a crypto-backed loan is to leverage a fraction of a cryptocurrency’s value without selling it, allowing holders to start spending their crypto while remaining exposed to potentially higher gains. However, this also exposes the borrower to the risk of liquidation if the price of the deposit falls too low.

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Taking out secured loans with no credit score was one of the first major breakthroughs of DeFi. Credit scoring is a crucial economic primitive in the traditional financial (TradFi) system, without which loans would be impossible to issue safely, but in DeFi a credit scoring system is almost impossible. To circumvent this limitation, DeFi developers created over-collateralized lending systems, where there is more collateral backing each loan than the value of the loan itself (ie, a user must deposit $100 in ETH to borrow $50 in stablecoins). Since then, over-pledged loans have been the dominant lending system of DeFi and will remain so until identity NFTs, blockchain IDs or soul-bound tokens are implemented to create a DeFi credit scoring system.

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The Aave protocol was created for over-collateralized lending and borrowing with cryptocurrencies, and Aave V3 is available across seven blockchains: Ethereum, Polygon, Avalanche, Fantom, Harmony, Arbitrum and Optimism. Aave’s FAQ section explains how users can deposit stablecoins and/or cryptocurrencies into their blockchain smart contracts, which automatically lend them to borrowers and send most of the interest payments back to the lenders. The interest rates for Aave’s crypto-backed loans are variable (by default) and depend on the number of assets available for loan versus the number of assets already borrowed. Borrowers can take advantage of 30 percent to 50 percent of the dollar value of their cryptocurrency deposits and even up to 82.5 percent of their stablecoin deposits. Aave uses a “liquidity pool“system, where lenders’ assets are pooled into a smart contract and from which borrowers take out and repay their loans.

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How are crypto-backed loans used?

While the most cited example of why someone would take out a crypto loan is to pay for emergency expenses or enjoy their gains without selling, most borrowers use crypto loans to create leverage for long or short trades. Exploitation is created through a “ladders” technique that involves borrowing against a deposit, buying more crypto from a decentralized exchange (DEX) like Uniswap, depositing the purchased crypto and then borrowing against the new deposit. By repeating this technique several times, users can increase their crypto holdings by approx. . as much as 95 percent, but this technique also increases the risk of liquidation if prices crash. Laddering/leveraging can open long positions by borrowing stablecoins to buy more crypto and sell it later. Alternatively, it can unlock short positions by borrowing and selling cryptocurrency to buy back later for cheaper.

Aave also offers some Defi-unique abilities. For example, when a user deposits crypto into Aave, they receive aTokens to represent their deposit (i.e. aETH, aUSDC, etc.) that accumulate interest paid by borrowers. aTokens can be bought and sold on DEXs, used in DeFi applications that take them, and fed to an Aavegotchi NFT pet to earn extra profit for the owner. Aave V2 also allows users to exchange their collateral through a simple exchange interface, which previously required the use of advanced flash loans.

Cryptocurrency lending and borrowing apps have become a staple of the DeFi industry and currently boast billions of dollars in value locked up in their smart contracts. The Aave protocol is the most popular of these apps, but Maker Protocol and Compound offer similar services. Aave allows crypto holders to access a fraction of the value of theirs cryptocurrency holdings without selling them, which they can use for emergency expenses, use their gains or open much riskier leveraged long or short positions.

Source: Aave, Aave Documentation, Aavegotchi

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