What's Crypto Lending?

Introduction

The concept of DeFi emerged around 2018, leveraging decentralized smart contract technology to replicate services provided by traditional financial institutions. These financial services are implemented through decentralized applications (DApps) which are running as code on blockchains. Capital lending is one of the most common services offered in traditional finance and holds similar importance in the crypto industry. The lending sector forms the foundational infrastructure of the DeFi financial system, representing a necessary choice for building the blockchain ecosystem.

The primary demand for crypto lending stems from two aspects. Firstly, it satisfies the capital needs of borrowers engaged in trading activities such as leverage, arbitrage, and market making, constituting the main demand. Secondly, it offers passive income opportunities for crypto investors (depositors) who wish to hold crypto assets long-term while generating additional returns.

The explosive growth of the DeFi ecosystem in 2020 was largely driven by the value explosion in the lending market. This was fueled, on one hand, by the liquidity mining frenzy initiated by lending protocol Compound, and on the other hand, by the composability among DeFi protocols driving the lending sector towards deeper development. As the crypto lending landscape has evolved, it has become more mature and well-defined. However, with the nesting of DeFi protocols, various niche markets or other lending scenarios have emerged, indicating a trend toward diversification.

How Crypto Lending Works

In traditional finance, the lending process involves four steps: deposit, borrow, withdraw, and repay. The participants in this process are depositors, borrowers, and banks. The bank acts as a third party, facilitating the lending operations between the two parties. Throughout the process, the bank performs three functions: record keeper, recording the deposits and repayment times of users; intermediary, facilitating the matching of borrowing and lending needs; and debt collector, pursuing repayment when borrowers default on their loans.

In crypto lending, users still engage in the four operations of depositing, borrowing, withdrawing, and repaying. However, interactions with banks are replaced by interactions with smart contracts because the process is decentralized.

Source: https://www.zuocoin.com/a/news/industry/2020/1115/115068.html

For depositors, when users deposit funds into a liquidity pool, they receive equivalent deposit tokens (such as cTokens) sent by the smart contract. These tokens accrue interest on deposits, and depositors receive the accumulated earnings when the lending relationship ends. The withdrawal process is the reverse: users return deposit tokens to the smart contract and receive their deposited assets.

For borrowers, when users need to borrow, they must deposit collateral. To ensure debt repayment, the borrowed funds are typically less than the value of the collateral. The repayment process is the reverse: users return the borrowed amount and any accrued interest to the smart contract.

Types of Crypto Lending

Floating Interest Rate and Fixed Interest Rate

Cryptocurrency lending can be divided into two major markets: floating interest rate and fixed interest rate, depending on whether the interest rate fluctuates during the lending process. A floating interest rate means that the interest rate of the lending relationship will change with market demand during the term. When the interest rate rises, users need to pay a higher borrowing interest rate, and vice versa. A fixed interest rate means that the interest rate of the user’s loan is deterministic and does not change with market demand, and users do not need to pay a premium interest rate.

From the current development of the crypto lending industry, the lending giants AAVE, Compound, and MakerDAO, where funds are also concentrated, all provide floating interest rate models. In contrast, fixed interest rates are still in the early stages of development. For institutional investors who are market leaders, they need deterministic and predictable products to manage assets. As a result, there is still demand for fixed interest rates.

Fixed interest rates can be further divided into three categories according to the fixed method:

• Zero-Coupon Bonds: These are tokens issued at a discount that are tradable and have a maturity date. Users redeem the collateral upon maturity to settle the debt. This is a fundamental protocol in the fixed-rate lending space.
• Yield Tokenization: Similar to the concept of coupon stripping in traditional bonds, this involves splitting the user’s deposit into principal and yield components, and then packaging them separately into assets with fixed terms and fixed income.
• Risk Grading: This involves dividing the returns into senior and junior tranches. Senior tranches offer lower returns and lower risk, while junior tranches offer higher returns but usually require collateralization of senior tranche funds.

Overcollateralized Loans and Non-Overcollateralized Loans

Cryptocurrency lending can be divided into overcollateralized loans and non-overcollateralized loans based on the ratio of collateral to loan amount. In overcollateralized loans, the borrowed debt value is lower than the collateral value, and the user’s fund interest rate is relatively low. Non-overcollateralized loans refer to loans where users do not need sufficient collateral as guarantee, and these products can be further subdivided into partially collateralized margin trading, unsecured credit, and cryptocurrency-specific flash loans. Currently, the lending market is still dominated by the overcollateralized mode.

Flash Loans

Flash loans are uncollateralized loans pioneered by the Aave protocol. Unlike traditional loans that require collateral, this product allows borrowing without collateral. The uniqueness of flash loans lies in their execution within a single blockchain transaction. If the loan and repayment operations are not completed within the same block, the entire transaction is automatically reversed. Specifically, this refers to integrating the FlashLoan function into a smart contract. Funds are temporarily transferred to this smart contract to execute the actions specified by the trader. If both the borrowed funds and fees are returned to the lending pool within the same block, the transaction is successful. However, if the returned funds are less than the borrowed amount, the provided funds will be returned to the lending pool, and the transaction will be reversed.

The Core of Crypto Lending

Utilization Rate of Funds

Currently, most decentralized crypto lending protocols operate on the basis of liquidity pools to facilitate efficient matching of borrowing and lending demands. The utilization rate of funds refers to the proportion of the total value of assets borrowed by users to the total value of assets in the liquidity pool. When this ratio reaches 100%, it means that all deposited funds have been lent out. A low utilization rate may result in an underutilization of funds, while excessively high ratios may lead to a run on funds if depositors seek to withdraw their funds, potentially causing a liquidity crisis for the pool. Therefore, managing the capital utilization rate appropriately is a crucial consideration for crypto lending protocols.

Interest Rate

Most protocols dynamically adjust interest rates based on the utilization rate of funds. They typically set optimal utilization rate thresholds, where if the utilization rate exceeds this threshold, borrowing rates increase significantly to curb further borrowing demand and safeguard the safety of the liquidity pool. Meanwhile, deposit rates also increase to incentivize depositors to contribute funds, thereby restoring balance to the supply and demand relationship of the pool.

Liquidation

The design of the liquidation mechanism directly determines whether a user’s position will be liquidated and the liquidation price. Several factors can be considered in this regard:

• Collateral Types: Lending protocols often choose mainstream assets with high liquidity as collateral. High-liquidity assets have broader applications and higher values, which helps reduce the risk of receiving lower-quality collateral in exchange for the loaned funds.
• Collateralization Ratio: Lending protocols need to set relatively low collateralization ratios to ensure that the collateral assets can cover the debt in the event of liquidation. Generally, assets with higher liquidity have higher collateralization ratios, while those with lower liquidity tend to have lower ratios. The reasons for this are similar to the choice of collateral types.
• Oracle Feeds: Lending protocols rely on external asset prices as references for liquidation. However, relying on a single, shallow data source for price information can be vulnerable to manipulation, leading to abnormal liquidation accidents. Therefore, it is necessary to provide stable and diversified price feeds from multiple sources for lending protocols.

Gate.io Crypto Lending

Gate.io has launched leverage lending products, where users need to transfer funds from their spot accounts to the corresponding leverage accounts before they can use them. Users can input the amount they want to transfer.

Once in the leverage account, users can select the corresponding leverage asset, and the page will display the amount of available borrowed assets and the borrowing interest rate. Users can input the amount they want to borrow, and when it’s time to repay, they can simply click on the “Repay.”

Future Development

Crypto lending protocols are growing generally, with mechanisms being similar across the board. The breakthroughs of emerging new lending protocols primarily lie in the following two aspects. One is that due to the majority of lending protocols employing overcollateralized borrowing, which prevents funds from being fully utilized like in traditional lending markets, new lending protocols are striving to enhance capital efficiency by adopting partial collateralization or even uncollateralized approaches. Another is that leading lending protocols typically opt for mainstream assets with high liquidity as collateral. Conversely, less liquid assets with lower trading volumes and market capitalization, known as “long-tail assets,” may be overlooked by the market. Consequently, new lending protocols are continuously exploring the use cases for long-tail assets.