DeFi Lending — With Opportunity Comes Risk
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The Intelligent Insurer #69: DeFi lending offers an attractive passive income stream, but at what cost?
The DeFi lending market is gradually occupying a significant portion of the global financial lending space. This is thanks to the ease of accessing capital and the trustless manner of operation. Lending and borrowing are currently an integral part of the DeFi sector. While it offers an improvement compared to traditional systems, it poses new risks.
The latest Intelligent Insurer will offer a comprehensive overview of the traditional lending and borrowing market and how DeFi protocols are giving them a run for their money. We will also consider the risks that this aspect of the DeFi space exposes users to, and how they can protect their investments. Before that, here are some exciting updates from our development team.
Insured Finance software development update
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DeFi lending protocols disrupt traditional financial systems
In the traditional financial system, a lender provides a loan to a borrower and earns interest in exchange for taking the risk. The borrower posts assets such as real estate as collateral to obtain the loan.
In the DeFi ecosystem, lending and borrowing transactions are conducted in a decentralized manner. Parties involved deal directly with each other through smart contracts. These smart contracts contain the loan terms and are automatically executed when certain conditions are met. Usually, the loans are over-collateralized to account for unexpected expenses and risks associated.
DeFi loans are obtained by providing crypto assets as collateral on a platform in exchange for other assets. DeFi users can deposit their coins into a protocol’s smart contract and become a lender. In return, they receive the protocol’s native tokens representing the interest amount that can be redeemed later.
Combining loans with stablecoins on MakerDAO
One of the biggest and longest-running lending platforms in the DeFi space is MakerDAO. MakerDAO is a peer-to-peer organization built on the Ethereum network, and has developed a protocol for lending and borrowing cryptocurrencies.
Using crypto to borrow crypto can be very tricky due to their volatile nature. Since their prices fluctuate wildly, the amount borrowed and the amount paid back could differ over a short period. To solve this issue, MakerDAO uses a stablecoin called DAI to determine the lending rates and repayable amounts. By combining digital asset loans with its stablecoin, MakerDAO allows users to reliably predict the amount they have to pay back.
To draw a loan from MakerDAO, users must first deposit some ETH into a Maker smart contract to mint DAI. The smart contract creates what is called a Collateralized Debt Position (CDP), which is the loan taken from the Maker protocol. Users are then able to mint up to two-thirds of the US dollar value of the ETH locked up. In short, they must have at least 150% more collateral in their CDP than the debt they wish to take.
The user can trade these DAI tokens on the secondary market and against multiple cryptocurrencies or fiat currencies. When they are ready to unlock their ETH users pay back the loan along with any fees.
If the value of ETH deposited into the Maker smart contract falls below the initial value, the borrower is automatically closed out of their position. To get back their initial deposits from the MakerDAO ecosystem, the user would have to pay back the amount they received, plus a fee.
MKR, the native governance token of the MakerDAO ecosystem supports the DAI stablecoin and helps maintain its peg. Holders of the MKR token are the lenders of last resort. When ETH crashes and too many loans are liquidated at the same time, MKR is automatically created and sold to pay back the loans.
At the same time, borrowers pay fees in MKR and the penalties for liquidation are used to buy back MKR. The protocol ensures that there is always enough value in MKR to back up liquidated loans.
MakerDAO currently has more than 2.3 million ETH locked in it, which represents an estimated 2% of the current ETH circulating supply. According to data from DeFiLlama, MakerDAO is the leading DeFi protocol in the market and has a TVL of over $9.5 billion.
(Source: DeFiLlama)
The risks inherent in DeFi lending
As with most things in the financial world, when anything promises extremely high rates of return there is a catch. DeFi lending is no exception to this. Users are exposed to several risks that endanger the safety of their investments and also undermine their confidence in the industry.
When investors deposit their digital assets to a liquidity pool, they risk something known as impermanent loss. This occurs when the price of assets locked up in a liquidity pool changes after being deposited and creates an unrealized loss. Although it is limited in pools containing less volatile assets like stablecoins, the risk is not eliminated.
Additionally, DeFi users are exposed to the effects of flash loan attacks. Flash loans allow borrowers to draw hundreds of thousands of dollars in crypto assets without posting any collateral. However, the catch is that they have to pay the full amount back within the same transaction.
Since the entire process is decentralized, anyone can qualify for this loan and there are no limits to the amount they can borrow. Bad actors use this loan to drain assets locked in the liquidity pools of DeFi protocols, causing losses for investors.
While the industry is still evolving and new protocols are emerging to solve these concerns, DeFi users can protect themselves from these threats. First, it is crucial to verify the credibility of any project before investing. To accomplish this, users must be avid readers to enable them to thoroughly read the project’s whitepaper and all available information about .
Users must also check if the project they wish to invest in is audited by a reputable third-party firm. These audits are important as they point out vulnerabilities in the protocol’s code.
Ultimately, DeFi users must also add insurance products to their investment portfolios. These insurance solutions, such as the ones offered by Insured Finance, provide users with all-around protection against losses. With these products, investors can rest assured that their digital assets are secured at all times. They can fully realize the potential rewards inherent in DeFi system safely.
About Insured Finance
Insured Finance is a decentralized, peer-to-peer insurance marketplace. Users can request customized insurance on a wide variety of digital assets, thereby ensuring full protection. Those fulfilling requests can earn premiums and earn a competitive return on their capital. Claims are fully collateralized and settled instantly.
