What Is DeFi?
DeFi stands for Decentralised Finance.
While in traditional finance most financing is done via banks and finance companies, the blockchain enables this to be done without a middleman.
This means two strangers can lend or borrow money securely to/from each other instantly.
If you have crypto assets, you can lend these out via DeFi protocols and earn a return.
What You Will Need
DeFi is an advanced topic in crypto.
Before lending or borrowing on DeFi, you should have a sound understanding of:
- Gas fees
In this example, we will be lending money on a protocol called AAVE.
You will need:
- Some Ethereum tokens (ETH)
- Hardware wallet
How To Lend On AAVE
Head to app.aave.com and connect your Ethereum wallet.
You can do this through your Metamask.
You can download the Metamask extension for your browser here.
Remember, if you ever plan on connecting your Metamask to websites (such as AAVE), always use a hardware wallet.
I recommend Trezor.
Connecting without a hardware wallet will work, but it's much less secure.
You can also use the Exodus Web3 Wallet if your funds are in Exodus.
Once your wallet is connected, it will show which assets you have available to supply on AAVE.
You can see I have 15.53 Ethereum and 109.96 Chainlink available in my wallet:
You can also see the interest rate available on these assets.
If I lend out my Ethereum, I will be earning 1.93% in interest.
Let's go ahead and supply 10 of my ETH for lending.
Simply click the Supply button and confirm the details:
Once I confirm the supply of my assets, they will now be deposited into AAVE and earning interest.
You're now lending your crytpo assets on AAVE.
Your interest payments will be automatically added onto your balance.
Are My Assets Safe?
Of course, there are always risks to lending money anywhere.
However, DeFi protocols all have safety mechanisms in place to protect your assets.
Imagine you want to buy a car for $20,000.
You don't have enough cash, however, you have a house worth $1 million.
Obviously, you can afford the car. You're a millionaire.
However, it would be very stupid for you to sell your house to get some cash to buy a car.
What typically happens in this situation is you go to the bank and say, please give me $20,000, and I will sign over my $1 million house as security.
This is known as an overcollaterised loan.
You have put up $1 million of security to borrow $80,000.
Now, I want you to imagine the exact same scenario, but instead of having a $1 million home, you have $1 million in Ethereum.
That's how overcollaterised loans on DeFi work.
This means for someone to borrow my $12,000 in Ethereum, they had to supply ample collateral.
Let's say they put up $20,000 of crypto assets.
Your next question might be, what happens if the value of his $20,000 in crypto falls below $12,000?
Aren't you now at risk of losing my money?
No, AAVE doesn't let it get that far.
When the borrower's assets start falling to $15,000, $14,000, $13,000, they will get a margin call.
This means they get told they need to either pay off the loan or top up their collateral, otherwise they are at risk of being liquidated.
If they don't, as soon as the value of their assets hits $12,000 they will be auto-liquidated and your funds will be returned.
It's all built into the smart contract on AAVE and will be done automatically.
Your borrowers will always be liquidated before their collateral falls below the loan value.
Your main risk is with AAVE itself.
Are you confident the code is written correctly?
Can it be hacked?
Who is developing the code?
Can they be trusted?
These are the things that are likely to lead to a compromised investment.
AAVE is an open-source protocol, meaning the code is public for anyone to see. If you understand code, you can go and audit the protocol for yourself. If not, you will need to rely on other smart people who have already done it for you. You can view AAVE's audit history here.