You’ve heard the term, right?
DeFi.
Decentralised Finance.
Sounds fancy.
It’s actually pretty simple, and has been going on for centuries.
Crypto just made it way easier. And better.
In this article I’ll show you how DeFi is changing the world of finance, and how you could get a loan, for as much as you want, whenever you want, for whatever you want, literally in seconds.
What is DeFi?
When you need financing, where do you go?
The bank.
They will ask you questions like – where do you work, how much do you earn, what do you want the loan for? Then they’ll look through your bank statements to see how good you are at wasting money. Finally, they’ll decide, yes – we’ll give you some money, or no – go away.
This is traditional finance. Crypto nerds refer to it as CeFi, or Centralised Finance, because one central institution controls all the lending (the bank).
The opposite of that is DeFi, or Decentralised Finance.
Its goal is to decentralise and democratise lending – no single banking officer will decide whether you can have a loan for a new car or not. If you have the assets, you can get it instantly.
In a second, I’ll show you exactly how.
How Does DeFi Work?
In the current world of financing, there are three parties.
- Borrower
- Lender
- Depositor
Here’s how this works:
John has just gotten paid $5,000. He deposits it into his savings account. The bank pays him 2% interest.
The bank then takes this money and tries to find someone to lend it to. If they’re paying John 2% interest on it, they need to lend it out for more than 2% to ensure they’re making a profit.
Tim shows up at the bank and wants to buy a new car. He needs $5,000. The bank says sure, we’ll lend it to you for 11% p.a.
Tims says great! He takes the money, buys his new car, and starts paying interest on the loan until it’s paid off.
So in this scenario:
- John is the depositor
- Tim is the borrower
- The bank is the lender
Tim pays the bank 11%, the bank pays John 2% and keeps the rest as profit.
This is how the majority of loans work in traditional finance.
DeFi loans work exactly the same way, except the entire process is automated through a DeFi Protocol.
Let’s see how it works.
As an example, we’ll use the DeFi protocol AAVE.
AAVE is basically the replacement for the bank – it connects lenders and borrowers.
However, AAVE is not a company, and there are no loan officers. It’s simply a blockchain application.
Let’s replay the scenario.
John has $5,000 in crypto and wants to earn some yield. He deposits it into AAVE.
Tim wants $5,000 to buy a car. He connects his crypto wallet to AAVE. He asks to borrow $5,000.
The protocol connects them both and within seconds – boom – Tim has his $5,000, and John is now earning interest.
The Secret To DeFi: Overcollaterised Loans
I know what you’re thinking – how do you know Tim is going to pay the loan back? What if he just runs away with the money?
This is the brilliant thing about DeFi – it automatically overcollaterises all its loans.
What does that mean?
Let me use this example:
Let’s say you own a house worth $1 million.
While you’re on holiday in a beach town, you see a little holiday cottage on sale for $250k. You want to buy it.
You can definitely afford it, because you’re a millionaire (your home is worth $1 million), but you don’t want to sell your home to buy the holiday cottage. That would be silly.
Instead, you approach the bank to loan you money against your $1 million home.
That means you get to keep your assets and buy the holiday cottage.
By signing over your house as collateral, the bank can feel secure. They know they can sell your house and get the money back if you decide to run off and not pay the loan back. And they know their money is safe because your house is worth 4x more than the loan. In other words, the loan is overcollaterised.
Now – I want you to imagine the exact same scenario above, but instead of a $1 million house, you have $1 million in Bitcoin.
That’s how AAVE works.
Lending on AAVE
Let’s start with the lending side.
If you want to lend money on AAVE, you simply connect your wallet and deposit your crypto into the protocol.
In this screenshot, you can see I’ve newly deposited 10 ETH into AAVE:
The AAVE smart contract lends my crypto out to borrowers, and the interest I’m earning will be 1.79% p.a.
Remember, the loans are overcollaterised – as I’ve deposited $12,000, anyone who borrows those funds will need to have more than $12,000 in their wallet to supply as collateral.
The AAVE smart contract will lock those assets as collateral before releasing the loan.
If the borrower does not pay off the loan in the agreed time, AAVE will simply liquidate their assets and pay back my funds.
When I want to withdraw the funds from AAVE, I simply connect my wallet and request the withdrawal:
Borrowing on AAVE
Now that I’ve deposited ETH, I also have the option to use that as collateral to borrow.
Here is the current borrowing market:
Let’s say I want to borrow BUSD.
If I click Borrow I’ll be taken to the terms:
You should notice a few things here.
First – the max amount I can borrow is just over $10k.
Remember I’ve deposited $12k of ETH as collateral.
However, borrowing $10k will be risky. You can see in the first screenshot, when I enter the max allowed amount as my borrow request ($10.3k), my health factor is just over 1, and if I fall under 1 I will be liquidated. That means if the price of ETH falls just a little bit, I’ll get liquidated and lose all my assets. Not good!
A healthier amount to borrow is $3k. As you can see in the second screenshot, my health factor is 3.6. That means I’m overcollaterised over 3 times. The price of ETH could fall 66% and I’ll still be fine.
How This Works In Real Life
There are stories all over Youtube/Twitter/Tiktok/Insta of people using DeFi to get instant financing on apps like AAVE, Compound, Alchemix etc.
As long as you have the crypto to put up as collateral, the loan is instant, which is a complete gamechanger for so many industries.
Consider this:
You’re a property developer, and you’re currently working on a house that’s been fully financed by the bank. The project is expected to cost $250k, and the house is expected to sell for $400k.
However, you have some cost overruns, and now it’s looking like the project will actually cost $320k. You need another $70k.
You go to the bank, but since you haven’t got a buyer for the house yet, they refuse to give you more money. They want to look at the property and do more paperwork and it’s going to take a month or so.
You don’t have “a month or so” to sit around looking at an unfinished house. However, you do have $300k of crypto. You don’t want to sell your crypto, but you’re happy to post it as collateral.
You connect your wallet to AAVE, deposit your $300k in crypto, and request to borrow $50k in BUSD.
In less than 10 seconds, you have $50k BUSD in your wallet.
You sell your BUSD on EasyCrypto to convert it to NZD:
The next day EasyCrypto deposits $77k NZD into your bank account.
Literally in less than 24 hours you’ve gotten a $77k cash loan without making a single phone call, talking to a single loan officer, doing a single background check, or even answering a single question.
You finish the house. Sell it.
With the proceeds you buy $50k BUSD from EasyCrypto, deposit it straight into AAVE and pay off your loan. You collateral gets released safely back into your wallet.
Welcome to the future of finance!
What are the risks of using DeFi?
The risks of lending on DeFi are:
- Contract risk – The AAVE smart contract might have bugs that could compromise your funds. The code is open source and has a bug bounty.
- Liquidity risk – There may not be liquidity in your particular coin at the time you want to withdraw (this doesn’t mean you lose your funds, just means you need to wait).
The risks of borrowing on DeFi are:
- Market risk – If the crypto market falls sharply, the value of your collateral will also fall sharply and you may get liquidated and lose your assets if you’re not sufficiently collaterised.
- Interest rate risk – The AAVE protocol has a floating rate based on supply. If there is large supply of a coin, rate goes down to encourage borrowing and vice versa. This could swing during your loan term meaning your interest rate unexpectedly rises.
- Contract risk – The AAVE smart contract might have bugs that could compromise your funds. The code is open source and has a bug bounty.
AAVE has a writeup on risks associated with DeFi protocols here.
Getting started with DeFi
DeFi is an advanced topic in crypto.
Before lending or borrowing on DeFi, you should have a sound understanding of:
- Ethereum
- Gas fees
- Stablecoins
- Metamask
- Wallets
Most DeFi platforms are currently built on Ethereum. AAVE and Compound are two of the more popular ones you should get familiar with.
Do NOT connect to DeFi protocols without a hardware wallet. I recommend using a Trezor. You can read my guide about wallets here.
