How to Lend Crypto on DeFi?

Decentralized Finance (DeFi) has transformed the way people interact with money. Built on blockchain, it allows users to lend, borrow, and trade digital assets without relying on any central authority. One of its applications is DeFi lending, which allows users to earn passive income by lending their digital assets. It eliminates the need for traditional intermediaries and offers a more inclusive, decentralized way to access competitive interest rates while providing liquidity to the DeFi ecosystem.

Let’s understand how to lend crypto on DeFi, its benefits, and the risks involved.

What is DeFi Lending?  

DeFi Lending offers an alternative way for handling money and financial services by eliminating the need for traditional institutions, such as banks. It directly connects lenders and borrowers by relying on self-executing computer programs, known as smart contracts, running on blockchains such as Ethereum or Solana.

Users can lend, borrow, or trade digital currencies and earn interest on their holdings directly. DeFi lending is available 24/7 and can be accessed anywhere with an internet connection, a digital wallet, and sufficient funds to provide as collateral or to lend.

Key Terminology Explained

To fully understand DeFi lending, several key terms are essential. These concepts explain the core terminology of how lending works in Decentralized Finance (DeFi).

Collateral

Collateral is cryptocurrency that users need to lock up when borrowing to ensure they repay the loan. In DeFi lending, you should deposit more value in crypto than you are borrowing. It ensures that the lender has sufficient collateral to cover the loan even if the borrower defaults. For instance, a borrower needs to lock up $1,500 in Ethereum (ETH) to borrow $1,000 in USDC.

Over-Collateralized

In DeFi lending, loans are often over-collateralized, meaning the borrower deposits more collateral than the loan’s value, usually 1.5 to 3 times or more. It provides a safety net for both lenders and the lending platform to manage the volatility of crypto prices. For instance, if the value of a borrowed digital asset falls sharply, the excess collateral ensures lenders can still recover their funds.

Interest Rate 

Interest is expressed as the Annual Percentage Yield (APY), which a lender earns or a borrower pays. It varies widely based on the supply and demand of a digital currency and the DeFi platform. For instance, lending stablecoins like USDT might offer an APY of around 5-10%, while digital assets like ETH might offer a higher rate due to price volatility.

Liquidation

Liquidation is a leading concern for borrowers in DeFi lending. It occurs when the collateral value of a borrower falls below a threshold, typically when the value of digital currencies declines. If the collateral fails to cover the loan, the platform automatically sells it to repay the lender.

Flash Loans

DeFi lending also involves borrowing flash or short-term loans. These loans are borrowed and repaid within the same blockchain transaction without any collateral provided up front.

How Does DeFi Lending Work?

DeFi lending is the practice of borrowing or lending digital currencies. DeFi platforms, such as Aave and Compound, allow lenders to deposit their digital assets into a lending pool and earn interest. The interest rate automatically adjusts based on the supply and demand of a digital asset. For instance, a rising demand results in higher interest rates.

DeFi platforms use collateral in the form of other cryptocurrencies. It is a type of security that borrowers provide to balance the impact of crypto price volatility. The value of collateral is typically higher than the borrowed amount, a practice called over-collateralization.

Smart contracts manage the entire process. It includes holding the collateral, transferring borrowed funds, tracking repayment, and handling interest rates. As cryptocurrencies are volatile assets, prices can often drop. In such cases, if the collateral falls below the amount borrowed, the platform automatically liquidates the collateral via smart contracts to protect the lender.

For instance, if you own a digital currency, such as Ethereum (ETH) or USDC, you can lend it through a DeFi platform and earn interest. The borrower can acquire your assets only after the collateral is deposited. The platform uses smart contracts to set interest rates, handle repayment, and enforce loan terms. As a lender, you earn interest, while borrowers pay interest to access funds while keeping their crypto holdings intact.

Getting Started with DeFi Lending

Anyone can start DeFi lending by following these steps.

• Acquire digital assets: The first step to start DeFi lending is acquiring a cryptocurrency, such as ETH, USDC, or SOL. Users can buy these digital assets on leading cryptocurrency exchanges such as Binance, Bybit, and WEEX.
• Set up the wallet: Select a suitable crypto wallet to secure your digital assets. For instance, non-custodial crypto wallets like Trust Wallet or MetaMask offer better control over private keys and support protocols such as MakerDAO, Compound, and Aave.
• Select a DeFi platform: Research leading DeFi platforms where you can lend cryptocurrency. Check the platform’s collateral requirements, APY, and security.
• Lend or borrow: Deposit cryptocurrency into the platform’s lending pool to lend it and earn interest. As a borrower, you can lock up collateral and borrow against it.
• Monitor the position: As cryptocurrencies are volatile digital assets, keep an eye on your position. Monitor the collateral value when borrowing, and APY when lending. It helps manage assets effectively.

Advantages of DeFi Lending

DeFi lending offers unique advantages to users, including higher interest rates, accessibility, and transparency. Some of its benefits are listed below:

1. Accessibility

DeFi lending is open to anyone with internet access and a crypto wallet. Unlike traditional banking, there are no identity checks, lengthy approvals, or credit scores.

2. Higher Interest Rate

Lenders can earn higher interest rates by lending their digital assets on DeFi rather than traditional savings accounts. Interest rates in DeFi lending can range from 2% to 20% or even higher, based on market conditions. However, DeFi lending involves higher risk since digital assets are highly volatile.

3. Transparency

Each transaction in DeFi lending is recorded on a blockchain and verified by smart contracts. It allows users to understand how much crypto is lent, locked in a protocol, or borrowed. This builds transparency, and instead of relying on a bank’s promise, users can check everything themselves.

4. Flexibility

DeFi lending allows users to borrow or lend digital currencies, often with flexible terms. A lender can withdraw funds at any time, while a borrower can use loans for anything, such as paying bills and trading, without explaining. Additionally, DeFi is available 24/7 and can be easily accessed from anywhere.

Risks to Consider

The following are the risks associated with DeFi lending:

1. Smart Contract Vulnerability

Smart contracts rely on code that can contain bugs or vulnerabilities. It makes it easier for hackers to exploit such contracts and potentially drain funds from the pool. Once the funds are stolen, it is almost impossible to recover them. To avoid this, use an established DeFi platform like Aave or Compound that undergoes audits to minimize risk.

2. Liquidation Risk

Liquidation is a significant concern for borrowers in DeFi lending. As cryptocurrencies are volatile digital assets, a price drop can reduce collateral value and trigger liquidation. Therefore, stay updated on crypto market developments to make informed decisions to avoid liquidation.

3. Cryptocurrency Volatility

Interest rates in DeFi are tied to market conditions that can affect APY. For instance, a drop in the value of a digital currency can lower its demand, thereby lowering lenders' APYs. Lenders should be careful about the cryptocurrencies they lend and avoid lending assets with high volatility.

4. Regulatory Uncertainty

Cryptocurrencies are decentralized digital assets not managed by any central authority, such as a bank. Governments around the world are finding different ways to regulate decentralized platforms. Future laws can affect how DeFi works, thereby directly affecting users’ access to specific protocols.

Important Reads: 5 Blockchain Security Risks to Watch Out For

Useful Tips for Beginners

As a beginner, entering DeFi lending requires a cautious approach. The following tips can be helpful:

• Start with a small amount to understand the risk. Before committing more funds, learn how DeFi lending works.
• Diversify your lending or borrowing across multiple digital assets to reduce risk.
• Gas fees for DeFi transactions can be higher, particularly on the Ethereum network. Carefully understand the fee structure to minimize deposit and withdrawal costs.
• To avoid market volatility, consider lending stablecoins like USDC or USDT. These digital assets are pegged to the dollar and are less volatile than assets such as ETH.
• Stay updated on DeFi platforms by following protocol upgrades and market trends.  

Final Takeaways

DeFi lending offers an alternative to traditional borrowing and lending. It provides transparency and better opportunities to make passive income. However, the underlying risks cannot be ignored, and users need to safeguard their assets. Follow innovative yield strategies, stay up to date on new protocols with low collateral requirements, and verify cross-chain compatibility to make the most out of DeFi lending.

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