What is DeFi Lending

Last Update: September 16th, 2024

DeFi lending, or decentralized finance lending, is a crucial component of the crypto ecosystem that drives liquidity in the digital asset market. It enables users to lend and borrow funds directly, without relying on traditional banks or financial intermediaries.

Through lending platforms, users contribute to liquidity pools by lending their crypto assets, which others can borrow. In return, lenders earn interest on their contributions.

For example, imagine a user lending Bitcoin on a DeFi platform like Aave. This lending action adds liquidity to the system, allowing others to borrow that Bitcoin without needing a bank’s approval or paying high fees.

Without DeFi lending, small exchanges or cryptocurrency pairs might face higher slippage, which is when a trade executes at a price different from what was expected, often increasing costs. Additionally, markets lacking sufficient liquidity may experience higher volatility and could struggle to maintain operations.

By removing intermediaries and reducing trading fees, DeFi lending platforms like Compound and Aave allow for seamless borrowing and lending, promoting a more efficient lending and borrowing market across the entire DeFi ecosystem.

How Do DeFi Lending Platforms Work?

Traditional Lending vs. DeFi Lending

In the traditional financial system, lending is primarily handled by banks and institutional lenders, where borrowers receive funds in exchange for interest payments. Common products include certificates of deposits (CDs), treasury bills (T-Bills), and repurchase agreements.

For example, when you deposit money into a savings account, the bank lends that money out and pays you a small interest—making you a “lender” without you actively managing the process.

Centralized Finance (CeFi) vs. DeFi Lending

In the crypto world, lending operates through both CeFi (centralized finance) and DeFi (decentralized finance) platforms. With CeFi, platforms like BlockFi or Celsius take custody of your cryptocurrency, and you must complete a KYC (know-your-customer) form.

Although you can earn interest, this centralization introduces risks, such as potential hacks or mismanagement of funds, since the platform holds control over your assets.

On the other hand, DeFi lending protocols offer a more secure, transparent, and autonomous way to lend your crypto assets. Users retain full custody of their funds, eliminating the need for KYC forms or trusting third parties with their tokens.

Anyone with a crypto wallet can participate, making DeFi lending accessible and open.

How DeFi Lending Works

DeFi platforms, like Aave or Compound, rely on smart contracts—self-executing code built on the blockchain—to automate lending and borrowing. These DeFi lending platforms operate similarly to traditional money markets, where users supply their tokens to a liquidity pool. In return, they earn interest, often calculated as APY (annual percentage yield), which is determined algorithmically based on supply and demand.

For example, if you lend Ethereum on a DeFi platform, the smart contract automatically matches your funds with borrowers. The entire process, from lending to earning interest, occurs without human intervention, ensuring transparency and security for all participants.

Why DeFi Lending Is Preferred

Because DeFi lending allows users to maintain full control over their assets and avoid intermediaries, it’s often seen as a safer, more efficient alternative to traditional financial systems or CeFi platforms. The decentralized nature of DeFi eliminates middlemen, reduces fees, and provides financial freedom by making lending accessible to anyone with internet access.

How to Use Digital Currency as Collateral in DeFi Lending

DeFi platforms allow you to leverage your existing digital currency—such as Ethereum (ETH)—as collateral to borrow other tokens without having to sell your assets. This is especially beneficial if you’re bullish on a cryptocurrency like Ethereum in the long term but want to access liquidity for short-term trades. By using Ethereum as collateral, you can borrow other crypto assets and still retain ownership of your Ethereum, allowing you to benefit from any future gains.

For instance, if you hold 10 ETH and expect its value to rise, you can deposit your ETH on a DeFi lending platform and borrow stablecoins or other cryptocurrencies for trading. This way, you maintain your ETH holdings while gaining additional funds to invest in high-potential tokens, maximizing both long-term and short-term opportunities.

How Collateral Works in DeFi

On DeFi lending platforms, before borrowing tokens, users are required to provide collateral, typically in the form of a cryptocurrency with higher value than the loan amount. This system, known as over-collateralization, helps mitigate the risk of default, ensuring that the borrower will repay the loan. If the loan is not repaid, the smart contract automatically liquidates the collateral to cover the debt, protecting the lender.

For example, if you want to borrow $5,000 worth of stablecoins, you may need to provide $7,000 worth of Ethereum as collateral. This ensures that the platform can recover the loaned amount even if the borrower fails to repay. Over-collateralization is a fundamental feature of DeFi lending protocols, promoting trust and reducing the risk of bad loans.

What is Crypto Loan Liquidation?

Crypto loan liquidation occurs when the value of your collateral falls below the required level to cover the loan due to the volatility in the cryptocurrency market. This happens when the market value of the collateral assets—such as Bitcoin or Ethereum—drops below the amount borrowed, triggering a liquidation event to protect the lender from losses.

When you take out a crypto loan on a DeFi lending platform, you must provide more collateral than the loan’s value (known as over-collateralization). As long as the collateral remains higher in value than the loan, the loan term can continue indefinitely. However, if the collateral’s value dips below a certain threshold due to factors like a market crash or bearish conditions, the loan is at risk of liquidation. This means the platform will automatically sell or liquidate the collateral to cover the outstanding loan and any associated costs.

For example, if you borrow $10,000 in stablecoins by providing $15,000 worth of Ethereum as collateral, a sharp decline in Ethereum’s value could trigger a liquidation. To avoid this, you need to monitor the liquidation price and either repay the loan or add more collateral to maintain the required balance.

Being aware of your loan’s liquidation rates and keeping enough collateral in place are crucial steps in managing crypto-backed loans to avoid forced liquidation.

What are the best Decentralized lending platforms?

Here’s a list of the most popular and trusted DeFi lending platforms that offer secure, decentralized solutions for lending and borrowing crypto assets.

Top Decentralized Lending Platforms

1. Aave

Aave is one of the leading decentralized lending platforms. Built on Ethereum, it allows users to lend and borrow a variety of crypto assets by contributing to liquidity pools. Aave stands out for offering flash loans and rate-switching features. It uses smart contracts to ensure automated, transparent lending operations, giving users full control over their funds.

Aave users can lend Ethereum to earn interest or borrow stablecoins without having to sell their ETH. The platform allows switching between stable and variable interest rates to suit different market conditions.

2. Binance

Binance offers decentralized lending through its Binance Smart Chain (BNB Chain). Users can participate in liquidity pools or directly lend their crypto assets to earn interest. Binance’s DeFi platform ensures low transaction fees and fast processing, making it popular among traders and long-term investors alike.

Example: Users can lend BNB tokens on Binance and earn interest while maintaining full control of their assets, as transactions occur on a decentralized platform powered by smart contracts.

3. Compound Finance

Compound is a decentralized lending protocol that allows users to supply crypto assets like Ethereum and earn interest in return. Borrowers can access loans by locking collateral in liquidity pools. The platform’s governance token, COMP, enables users to vote on protocol upgrades and changes.

If you hold COMP tokens, you have the power to influence important decisions regarding interest rates, collateralization levels, and overall improvements in the platform.

4. YouHodler

YouHodler is a multi-functional lending platform offering both CeFi and DeFi services. It allows users to lend and borrow crypto assets while earning competitive interest rates. Users can lock collateral and get access to loans in various cryptocurrencies.

YouHodler users can borrow Bitcoin while using Ethereum as collateral, allowing them to engage in other investments without liquidating their ETH holdings.

5. Nexo

Nexo offers an innovative DeFi lending solution where users can borrow against their crypto assets or earn interest on their holdings. With a focus on user-friendly experience, Nexo offers high-yield interest accounts, and its NEXO token provides benefits such as increased yields and lower borrowing rates.

Lend your USDC stablecoins on Nexo to earn daily interest without needing to deal with banks or financial institutions.

6. Balancer

Balancer is a unique decentralized exchange that also offers lending and borrowing services. It operates liquidity pools where users can earn interest by providing crypto assets, supporting a wide range of token pairs. Balancer’s automated market maker (AMM) feature allows for dynamic allocation of capital, ensuring optimized returns for lenders.

Balancer users can create custom liquidity pools with various assets, lending multiple tokens to maximize earning potential.

7. Jet Protocol

Jet Protocol is built on the Solana blockchain, offering a highly efficient and low-cost DeFi lending platform. It allows users to borrow and lend crypto with lower fees and faster transaction speeds compared to Ethereum-based protocols.

Users on Jet Protocol can leverage Solana’s speed to lend and borrow assets like SOL or USDC without incurring high fees, making it an attractive option for active traders.

8. Compound Interest

Compound Interest is an extension of the Compound Finance protocol, allowing users to earn competitive interest rates by lending their assets. The protocol adjusts interest rates algorithmically based on the supply and demand within the platform’s liquidity pools.

If the demand for borrowing a specific token increases, Compound Interest automatically raises the interest rates, allowing lenders to earn more.

9. BNB Chain

The BNB Chain (formerly Binance Smart Chain) powers decentralized lending through its vast DeFi ecosystem. It provides fast and low-cost transactions, making it an attractive option for lending and borrowing various digital assets.

Users can lend BNB or BEP-20 tokens on the BNB Chain and earn interest while taking advantage of its fast processing and low gas fees.

10. Curve Finance

Curve Finance specializes in lending stablecoins with minimal slippage and low transaction fees. It operates liquidity pools that are specifically designed for stablecoins, making it an efficient platform for lending or swapping without losing value to volatility.

Curve allows users to lend USDT, USDC, or DAI to liquidity pools, offering a stable and predictable interest return due to low volatility.

11. Cream Finance

Cream Finance is a lending platform similar to Compound but with a focus on a wider variety of tokens. Users can lend or borrow lesser-known cryptocurrencies, making it an appealing option for those looking to engage in more niche markets.

Lend lesser-known assets like LINK or UNI on Cream Finance, which may offer higher interest rates due to reduced liquidity.

12. Yearn Finance

Yearn Finance is an advanced DeFi platform that optimizes lending strategies through automation. It automatically moves assets across various lending protocols like Aave or Compound to find the best yields for users, reducing the manual work of yield farming.

Users deposit assets into Yearn Finance’s vaults, and the platform continuously reallocates them to earn the highest possible interest across the DeFi market.

13. Apricot Finance

Apricot Finance offers a risk-adjusted decentralized lending platform built on the Solana blockchain. It focuses on providing low-fee, high-efficiency loans by leveraging Solana’s fast transaction speeds.

Lend SOL tokens on Apricot Finance and enjoy the benefits of low fees and fast transactions, along with risk management tools.

14. DeFi Swap

DeFi Swap offers decentralized lending and staking services, where users can provide liquidity to various pools and earn interest or rewards. The platform is known for supporting a wide range of tokens, including stablecoins and altcoins.

By staking your crypto assets on DeFi Swap, you can earn interest rates that adjust based on the market’s supply and demand dynamics.

15. Lido Finance

Lido Finance provides decentralized staking services, enabling users to stake Ethereum and other PoS assets while retaining liquidity. Users can lend these staked assets through the platform to earn interest without losing the ability to trade.

Staking ETH on Lido allows you to earn interest while receiving stETH, which can be used as collateral for other DeFi activities.

16. Ethereum

As the foundation of many DeFi protocols, Ethereum powers the majority of decentralized lending platforms. Users can lend or borrow Ethereum-based tokens like DAI, USDC, or LINK on multiple DeFi platforms that rely on Ethereum’s secure, decentralized network.

Lend ETH on platforms like Aave or Compound, and earn interest while keeping your assets on the most widely adopted blockchain network.