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What Is It All About: DeFi Lending, Stablecoins, And Interest Payments

Elias Mendel
Sep 30, 2021 12:01:25 AM

Over the past few years, as the awareness about and use of cryptocurrencies and decentralized finance (DeFi) has been growing exponentially, DeFi lending protocols have gained tremendous traction. Their independence of central authorities, competitive interest rates, and relative novelty keep leading intrigued investors wishing to earn more than their lousy 0.1% savings account interest payment to the likes of Aave, Compound, or Kucoin. Through these platforms, they can provide their tokens to deposit reserves allowing them to earn significantly higher returns.-Author: Elias Mendel

 

A key metric to consider when looking at the DeFi space and its general health is the Total Value Locked (TVL), which, in simple terms, quantifies the value of all assets that are being supplied and staked on specific protocols, such as DEXes or lending sites. 

A quick view of the figure over the past years depicts the rapid rise of this industry. Figure 1: TVL in DeFi via DeFi Pulse

As of this writing, more than $89 billion are locked in DeFi protocols, including $45 billion in lending, with several platforms sharing major parts of the market among themselves. We will examine the largest players and compare the reported APYs for different coins and tokens. 

What is DeFi lending? 

While the purpose of DeFi lending, similar to regular lending using traditional banks, is the provision of funds for those willing to pay a premium (the interest), the way it works noticeably differs.

Lending and borrowing takes place entirely autonomously and is governed by protocols without any humans intervening. Said protocols do not require you to undergo any credit assessment test or provide any further identification and financial record. Given that you have the necessary funds available in your wallet to collateralize the loan, you are good to go. 

Instead of an intermediary institution that handles the process of collecting and distributing capital, smart contracts are executed once certain criteria are met. Also, bear in mind that when using fully automated and decentralized protocols like Aave or Compound, you are the only one responsible for storing your assets and keeping them safe, the platforms do neither take custody nor liability for any of it. 

Every block, lent assets accumulate interest, while borrowed assets are charged interest.

The lion’s share of the interest paid is returned to the asset pool and a small part is kept aside as protocol reserves, serving as a cushion in the event of oracle failures, major liquidations in a short period (might lead to increased slippage), or, any other bugs.

When it comes to collateralization, pretty much all loans are overcollateralized, meaning the amount a borrower has to set aside exceeds the amount they will be able to borrow afterwards. 

The relevant figure, in that case, is the collateral factor which varies from asset to asset. 

For example, on Aave, if your collateral consists of Chainlink, you are able to borrow up to 70% from what you supplied, or up to 80% in Ethereum’s case. 

If the collateral’s value depreciates and the liquidation threshold is being fallen short of, the collateral gets liquidated to repay the borrowed sum. The liquidation threshold is slightly higher than the collateral factor, ensuring that the borrower’s sum can be fully repaid in spite of slippage or rapidly declining prices (some sort of safety margin). 

As long as the threshold is maintained, however, also taking into account the due interest payments, there is no limit as to how long funds can be borrowed. 

In Figure 2 below you can see the mechanics of the DeFi lending process. In case you are wondering what cTokens or aTokens stands for, these are the DeFi lending platforms’ native versions of the token supplied (cToken for Compound, aToken for Aave) which are used to keep track of the funds supplied as well as any interest accrued. 

For example, if you provide 1,000 DAI to Compound, you will receive 49,825.61 cDAI in return (exchange rate cDAI/DAI= 0.020070). Several months later, when withdrawing your cDAI, you will notice they are now equivalent to 1,075.78 DAI (exchange rate = 0.021591), meaning your cDAI appreciated in value in comparison to DAI. That way, interest is being paid to the lenders. Neat, right?

Although Aave makes use of a slightly different, more traditional approach to pay interest, their aTokens are also at the core of every lending process. 

Figure 2: A simplified view of the lending and borrowing process

Comparison of main platforms

To make this article more practical, we have gathered some information about the interest rates and APYs you can expect on the largest DeFi lending platforms. 

Note that we only focus on variable interest rates - which can quickly change depending on lending supply and borrowing demand - as these are more common and sought after.

The following numbers are what you can expect when you deposit funds to one of the protocols.

Figure 3: APY on Aave

Figure 4: APY on Compound

Figure 5: APY on Cream

Although the APYs differ between the protocols, it is visible that on any of them the highest interest payments are being made for stablecoins. Why is that? 

Why do stablecoins have the highest returns?

Stablecoins are a major backbone of cryptocurrency trading. Prior to their emergence and increased popularity, one would have to use fiat money and other cryptocurrencies to transact with. However, since this brings along some downsides - volatility and/or slower, more expensive execution - stablecoins pose a more apt way to trade seamlessly and boost liquidity on the markets. 

This is linked to another reason why borrowers are willing to pay more interest on stablecoins, which, as the name suggests, is their stability. Stablecoins are oftentimes being transferred quickly between various exchanges by arbitrageurs to exploit price inefficiencies. For this kind of strategy to work in the long run, one ideally has a stable “base” amount to transact with rather than tokens that are constantly fluctuating in value. Similar applies for Dapps which require stable prices to be used and transacted upon.

Also, over time one could observe a steady surge in stablecoin-quoted trading pairs (xyz/USDT, xyz/USDC, xyz/BUSD etc.), a further driver of demand. 

Furthermore, an aspect to bear in mind is the current state of the market. Whenever you find yourself in a bull market you will see interest rates, and hence demand, for stablecoins soar, as illustrated in Figure 3. This is because as prices rise and traders suffer increasingly from severe FOMO they will seek to leverage their positions to maximize their gains. On the other hand, when there is a bear market, interest rates for stablecoins drop noticeably since the general trading volume usually declines. In fact, during those times you can occasionally see the interest rates of volatile non-stablecoins rise as traders look to borrow and short sell them.Figure 6: USDT Borrow Rates via DeFi Pulse - notice how they are extremely high during the bull run until May and than rapidly sink

All the aforementioned aspects do lead to a steady and massive demand for stablecoins, and as basic economic understanding suggests, high demand leads to high prices, in this case in the form of above-average interest rates.

Final thoughts

The DeFi sphere, including DeFi lending, has grown substantially over the past years, almost scratching the $100 billion mark of TVL. DeFi lending encompasses extensive protocols with up-to-date features and distinctive characteristics (e.g. the over-collateralization), and is thus growingly competing with traditional finance. 

A steady demand exists for the crucial stablecoins, which are some kind of glue stabilizing the entire ecosystem, rendering it more mainstream-accessible and easier to interact with. They help ensure the crypto sphere advances as a whole, and staking stablecoins in liquidity pools is rewarded accordingly with high APYs. 



Remarks

About Sharpe Explorer: At Sharpe Explorer, we help our customers leverage the crypto and DeFi revolution to access predictable returns, optimize their portfolio and gain a competitive advantage. Our mission is to provide the best and most trusted user experience for investors in the market. We are going to be the one-stop shop for the focused and comprehensive assessment of any DeFi asset. Sharpe Explorer is going to open the door to the world of DeFi and will give you direct access to wallets and DeFi protocols.

Interested? Then, contact us via info@sharpeeplorer.io, or visit our website. For more content, follow us on LinkedIn, Medium, or Twitter

Do you know someone who might be interested? Then share it on social networks or forward it to your colleagues. Thank you.

Author

Elias Mendel studies International Business and Economics at the University of Applied Sciences Schmalkalden. Currently, he works on several projects dealing with DLT, digital assets, and blockchain. You can contact him via email.

Ressources

  1.  https://defipulse.com
  2.  https://edge.app/blog/de-fi-compound-finance/
  3.  https://finematics.com/lending-and-borrowing-in-defi-explained/
  4.  https://docs.aave.com/risk/asset-risk/risk-parameters
  5.  https://compound.finance/docs/ctokens
  6.  https://www.coindesk.com/markets/2020/12/29/what-is-a-stablecoin/
  7. https://www.reddit.com/r/CryptoCurrency/comments/ll1eul/how_are_stablecoin_interest_rates_so_high/
  8. https://defipulse.com/defi-lending













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