Hello Lobsters! Welcome back to Lobster Academy, where we explain in simple terms the different DeFi technologies.
In today’s episode, we’re diving into one of the first types of DeFi protocols — lending and borrowing. Let’s explore how these protocols work, the risks involved, and why they can be beneficial for your crypto journey!
Lending and borrowing in DeFi mirror traditional finance but with a decentralized touch. In simple terms, lending involves providing your crypto assets to others in exchange for interest. Pretty easy to understand.
Borrowing means taking out a loan using your crypto as collateral and paying interest to the lender. However because there is no KYC required to use these protocols, the user must over-collateralize their loan to ensure repayment. It means that if you want to borrow $75, you would need to deposit at least $100 worth of collateral.
One core concept in DeFi lending is the Loan-to-Value (LTV) ratio, which determines the maximum amount one can borrow against a given amount of collateral. For instance, if the LTV ratio is 50%, a user can borrow up to $500 worth of assets by providing $1,000 worth of collateral. The specific LTV ratios vary across different platforms and assets, depending on their volatility and liquidity.
Unlike traditional banks, DeFi platforms use smart contracts to automate these transactions, making them more accessible, transparent, and permissionless.
While DeFi offers many advantages, it’s crucial to understand the associated risks.
One significant risk is smart contract vulnerabilities. Since these contracts are pieces of code, any bugs or flaws can be exploited, potentially leading to significant losses.
Market volatility also poses a considerable risk. In DeFi, assets used as collateral can experience rapid price changes. If the value of the collateral falls below a certain threshold (often called the liquidation threshold), the protocol may automatically liquidate the collateral to cover the loan, potentially causing losses for the borrower.
Despite the risks, lending protocols offer several important benefits. For lenders, these platforms provide a way to earn passive income by putting their sleeping assets to work. Imagine earning interest on your crypto just by lending it out — sounds great, right?
For borrowers, these protocols provide access to liquidity without needing to sell their assets. This can be especially useful if you believe in the long-term value of your crypto and don’t want to part with it.
You can use your assets as collateral, get a loan, and still retain ownership, potentially benefiting from future price increases.
Some of the most well-known DeFi lending platforms include Aave ($13,175b TVL), Compound ($2,2b TVL), and Morpho ($1,805b). These platforms have built strong reputations for security and innovation. Aave, for instance, is known for its wide range of supported assets and features like flash loans, which allow borrowing without collateral as long as the loan is repaid within the same block.
Compound is another popular platform, offering a simple and efficient way to earn interest on a variety of crypto assets.
Morpho is also a lending platform gaining much traction recently. The particularity of Morpho is its on-chain peer-to-peer layer on top of lending pools.
Lobster’s strategy leverages Aave for several key reasons:
The key challenge is maintaining the balance between the long and short positions despite market volatility. This balance is crucial for risk management and optimizing returns. Fortunately, our algorithm handles this automatically, ensuring that the strategy remains balanced and optimized.
And that’s a wrap for today’s episode of Lobster Academy! Remember, while lending and borrowing in DeFi can offer fantastic opportunities, always DYOR (Do Your Own Research) and understand the risks involved. Stay curious, stay safe, and keep exploring the fascinating world of DeFi!
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