The concept behind DeFi lending isn't new: It's like any other lending program. You need money. You find a place that will lend you money. You get the cash, you pay it back over time with interest, the lender makes a profit, and that's that. Fairly simple.
But for all its similarities, it's also vastly different - and has the potential to completely reshape lending as we know it.
First things first, what is Defi?
DeFi - or Decentralized Finance is an open-source market that enables peer-to-peer borrowing and lending. There is no centralized bank or government agency. No third-party intermediary. It's direct and to the point and only concerns the person who is borrowing the money and the person who is lending it. It's an alternative to traditional banks and lending services and operates in the cryptocurrency space.
How it works
DeFi uses smart contracts, an "automatic and self-executing agreement that operates without the need of a central authority or rent-seeking third party." (Basically, it means no one else is sticking their nose in your business.) The buyer and seller come to an arrangement which is then written into lines of code. All transactions are trackable and irreversible, and the code ensures that everyone is fulfilling their end of the bargain.
How does it benefit the borrower?
Traditional loans typically require a bit of red-tape navigation, including an application, credit check, KYC (Know Your Customer), and a personal essay about why you need to borrow the money. (Just kidding about the essay part.) But somewhere, possibly thousands of miles away, someone is combing through your personal and financial information to determine if you are worthy of being granted a loan. You may get it. You may not. You have very little say over the matter.
But DeFi lending is free of third-party regulation or interference. That means no KYC. No questions asked. No explanation of why you need to borrow money. It's quicker, simpler, and more efficient.
For those who have trouble securing a traditional loan, DeFi lending is a great alternative. While a conventional lender may require a good credit score (which can influence how much you can borrow and at what interest rate), DeFi doesn't have those restrictions. Virtually anyone can borrow money regardless of their credit history without reason or explanation. And the best part is, you have access to your borrowed funds almost immediately.
How does it benefit the lender?
Being on the lending side of things can be an excellent opportunity to increase your assets. Crypto can be volatile, and prices can go through fluctuations of increase and decrease. It also doesn't earn interest, so leaving it sitting in your virtual wallet may not be doing you a whole lot of good. DeFi lending is a chance to make your crypto work for you; after all, it's what banks and loans sharks, and lending clubs have been doing for years.
Are there any downsides?
There's always the other side of the coin, and while DeFi lending has plenty of advantages in its corner over traditional lending, there are still a few downsides and risks to consider.
One thing that traditional finance systems have going for them is that they are closely regulated and require licensing, which is not always the case with DeFi. Users should enter into any agreement aware of the risks of operating in an unregulated space. More than $10 billion was lost in DeFi scams and thefts just last year, and money laundering activity increased by 30%. It's not surprising that it's been referred to as the Wild West.
DeFi lending is not charity. True, there is far less scrutiny involved in the process, but that doesn't mean you're getting something from nothing. Just like the bank will seize your car if you default on your payments, DeFi loans require something in return. You will need to cough up some collateral in the form of a digital asset like ETH or Bitcoin. And it has to be more valuable than the amount borrowed. (For instance, if you want to borrow a Bitcoin, you have to deposit at least the price of one Bitcoin.)
There's also a chance the whole thing could collapse. Some liken DeFi to a "fool's gold rush" and compare it to the 2008 financial crisis. That is a sobering thought.
What does this mean for the future of lending?
DeFi can potentially reshape the way money is exchanged for future generations. Creating a "classless" egalitarian system for borrowing and lending opens up the opportunity to a broader audience. Anyone can become a lender, regardless of where they live or how much capital they own. There are no service fees or transaction fees imposed by third-party institutions. It's truly a "for the people, by the people" concept.
The question we must ask ourselves is if the reward is worth the risk. DeFi appears to be holding up well despite the crypto market being down, but there's still a considerable potential for fraud and scams. It may not be the platform of choice for everyone when all is said and done, but it sure is nice to have another choice.