How DeFi Lending Pools Work
General - August 25, 2020
Before we look at DeFi or what DeFi coins are out there in the market, we should understand what DeFi is building. Essentially, decentralized finance is changing the way we look at banks,
We usually think of banks as these gigantic institutions which offer a range of services. But, in reality, a bank has two basic functions – take money in and give money out.
A bank receives money from someone who saves and lends money to someone who borrows. It’s that simple. However, they often charge a whole bunch of fees for this simple but important and necessary process.
DeFi lending pools aim to bring together these two banking functions but without an intermediary. So, what do they replace the bank with? Simple, they replace the bank with ‘code.’
Several protocols in the DeFi lending space like Compound, bZx, and Aave are building code-enabled algorithms which answer the three most important questions when it comes to lending and borrowing:
- What do people want to borrow and lend? This is usually something stable, which can be used for daily transactions.
- What can people collateralize? This is usually something valuable, that can be sold if the loan is not paid back.
- What is the interest rate? This is the ‘incentive.’
In the above three questions, the most important is the third. The question of incentives is also the question of supply and demand. These algorithms automatically adjust the rate of interest to lenders and borrowers depending on the demand for borrowed funds, and the supply of loaned funds. This is where things get a little tricky, because demand and supply are after all, based on incentives.
Do I have an incentive to lend? Do I have an incentive to borrow?
These incentives are constantly altered based on the changes in price of – what is borrowed and what is collateralized. Since stablecoins like DAI, USDT, USDC are typically borrowed, their price is fixed and we don’t have to worry about them. But the price of cryptocurrencies like ETH, BTC, or LINK which are typically used as ‘collateral’ are never stable.
Naturally, the incentives fluctuate.
Because of this rapid change in price these lending pools and their algorithms constantly change many variables within the system. Variables like the interest paid to lenders, the interest received from borrowers, the liquidation ratio of the cryptocurrencies collateralized, and more.
But these ‘rapid changes’ are making the system better. Since the change in interest is a function of the change in price, the DeFi lending pools are representative of the market and not just arbitrary in nature. And all this is without any fees and friction.
In this video, we talk about the flexibility, customization, and composability of these lending pools.
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