One of the earliest extant written documents are tablets from Mesopotamia with records of receipts and expenses, food rations, and debts for the lease of temple lands, the amount of which was stated in grain and silver terms.
In this way, non-cash payments appeared already at the dawn of a civilized society and the next technological round of the ancient idea is happening now in the world of blockchain and cryptocurrencies.
For centuries, loans have been a source of financial flows that filled civilizations. Banking institutions and government services traditionally controlled them. And while that system hasn’t gone anywhere, the emergence of the blockchain has helped to create new ways of financial relationships that don’t involve a third party.
DeFi — A Breakthrough In The Crypto Industry
The DeFi (decentralized finance) system, which emerged a few years ago, is designed to fundamentally change the existing borrowing pyramid and give humanity a new toolkit for financial activity.
As of 2019, DeFi has been considered as a new stage in the crypto industry evolution, one of the most attractive blockchain ecosystems. Historically, most DeFi solutions are built on the Ethereum platform, but any blockchain that executes smart contracts can act as their basis.
DeFi is an ecosystem that is a set of smart contracts that allows providing financial services without traditional centralized intermediaries: banks, brokers, and crypto-exchanges.
DeFi covers all aspects of financial services and transactions, including lending, borrowing, and trading within decentralized structures. The terms of the transaction are recorded directly in the blockchain smart contract, and the transaction is executed only if the conditions controlled by the smart contract are fully met.
The entry threshold for users is still high and this is primarily due to the greater complexity of using DeFi tools compared to traditional banking solutions. After all, most of the financial mechanisms hidden inside banks in DeFi ecosystems are open to the user.
P2P — From Me To You
The basic idea of the borrowing mechanism is P2P: from one user to another. The goal of such a borrowing service is to connect the party interested in getting a loan with the party looking for additional income. The functional role of the service directly based on the blockchain is reduced to the search for potential borrowers and lenders, conducting a reliable assessment of the client’s ability to fulfill its obligations under the loan agreement.
Assistance is provided in signing contracts and agreements that control the proper performance of obligations: sureties, pledges, guarantees. In all other respects, the parties are left to themselves. The once-popular Ethereum loan service, ETHLend, was based on the same principle.
However, the P2P online borrowing system has several features that limit its attractiveness to customers: there is not very high liquidity, there are obvious difficulties in finding responsible borrowers and lenders. As a result, other, more complex interaction platforms have become relevant in decentralized finance.
Liquidity Pool: Applications For Money Growth
In terms of cash flow, there are three leaders in DeFi’s borrowing services: the MakerDAO, AAVE, and Compound platforms.
In the past, it was quite difficult to use cryptocurrency for lending. Most crypto assets fluctuate greatly, so the amount someone borrowed in cryptocurrency and the amount returned could be very different even in a short period. MakerDAO solved this problem.
MakerDAO is a platform that develops technologies for borrowing, saving, and issuing stablecoins on the Ethereum blockchain. The protocol allows Ether holders to lend money as a stablecoin called DAI.
DAI is created by smart contracts based on the loan and repayment process with excessive collateral.
Users who deposit Ethereum can borrow against their deposits and receive generated DAIs. The collateral ratio for ether is currently set at 150%, in other words, depositing 150 dollars worth of Ether allows you to borrow up to 100 DAI, which is equivalent to about 100 USD. Subsequently, when Ether goes up in price, it is possible to buy back the deposited amount of Ether for the same $150, although its market value is already higher. In addition, with the borrowed 100 DAI or 100 dollars, you can buy the same Ether and repeat the entire operation. The ability to borrow and invest the borrowed amount in growth is the main advantage of the platform.
AAVE was born out of ETHLend when the application mechanism was changed from P2P to a liquidity pool. AAVE differs from its competitors between cryptocurrencies in which users can borrow and the additional features: instant loans, a delegation of borrowing rights, and a choice between fixed and variable interest rates.
AAVE implemented a liquidity pool system in which crypto loan assets were pooled together and interest rates were determined algorithmically based on the type of borrowed assets. Under the new system, if an asset is in short supply, interest rates are set higher to encourage lenders to contribute more, and vice versa, if there is a significant supply of an asset, interest rates are lowered to encourage borrowers to borrow.
AAVE provides loans in a variety of cryptocurrencies, but under the pool system, borrowers must deposit collateral above the amount they borrow. To account for the volatility of cryptocurrency markets, the AAVE protocol has an algorithm that automatically liquidates the borrower’s collateral if its value falls below a specified ratio. Every loan in the network is managed by a smart contract, which is verified by third-party auditors.
All assets in AAVE are tokenized. After making a deposit, the user receives a-tokens to his wallet, to which he then receives interest. When receiving a loan, the user is given Debt-tokens, which are then burned when it is returned.
In addition, the project has its own token — AAVE, which is used to manage the protocol and secure loans.
Compound is similar to AAVE in terms of how it works: users deposit assets into the liquidity pool. Interest rates are adjusted algorithmically with each new Ethereum block depending on supply and demand. The user receives interest on deposited funds.
After making a deposit, Compound provides the lender with a new cryptocurrency — c-token. Ethereum becomes cETH, DAI becomes cDAI, etc. C-tokens can be transferred, loaned, or traded without restrictions. But c-tokens can only be exchanged for a cryptocurrency that was initially locked in the protocol. The entire process is automatic and handled by Compound code, i.e., lenders can withdraw deposits at any time.
The deposited funds allow the user to receive a loan — up to 75% of the available balance. There can be several loans and there are no predetermined loan terms within the platform. The user pays interest for obtaining a loan.
Compound uses its own cryptocurrency, COMP, to manage the Compound protocol on the DAO model. Each time a user interacts with a composite market (by borrowing, withdrawing, or paying out an asset), they are rewarded with additional COMP tokens.
Despite its complexity, the platform has proven its ability to attract users and encourage other DeFi-platforms to adopt its model. According to DEFI PULSE, as of 2020, more than $500 million in assets have been locked up in the Compound protocol.
Since decentralized finance is one of the most important elements of the modern financial ecosystem in the world of cryptocurrencies, the search for conceptual solutions in DeFi also takes place in the Free TON community.
These days, voting is underway for an essay contest on collateral service projects — Lending and borrowing on FreeTON. We will definitely tell you about the works that received the highest score.