February 3, 2022
Decentralized lending/borrowing is not an intuitive concept.
The most common confusion comes from the fact that borrowers today have to *overcollateralize* their position to receive a loan in DeFi.
Overcollateralize = put up $150 in collateral to get a $100 loan. Why would anyone do this? Isn’t the point of borrowing to access capital that you don’t have?
Well, yes. However, there are several reasons that someone in the DeFi world would overcollateralize for a loan.
Here are a few. None of this is financial advice and all of this is risky.
– You have 1 ETH and you think the price is going higher but don’t have the cash to buy more. You deposit your ETH into a DeFi protocol and receive 50% worth of USDC (dollar-backed stablecoin). You go and buy .5 ETH with your USDC. Let’s say ETH doubles. You now have a total of 1.5 ETH ( with a USD value double what you started with). You close out your loan – now with 1.5 ETH (less interest paid) instead of the 1 you had when you started.
– You have 1 ETH worth of USDC and you think the price of ETH is going lower. You deposit your USDC and borrow .5 ETH with it. You immediately sell the ETH you borrowed. The price drops 50%. You buy back the ETH and repay your loan. Your ETH holdings just doubled due to access to the loan.
– You notice that you can get a loan at 3% on one asset or protocol and earn 7% on another. You deposit $100 of USDC to get a $50 loan (paying 3%). You take your loan and deposit it elsewhere earning 7% to take the spread.
Avoiding capital gains taxes from selling assets is another reason a user might take a loan in DeFi.
Because these markets are nascent, and because many of the assets borrowed and loaned against are volatile in price, there are many interesting opportunities for traders that are not available in traditional finance.
Furthermore, users *control* their assets. This is a concept that does not exist in traditional finance.
Imagine if you could take a share of Apple in your TD Ameritrade account, stake it, and access a loan with it to buy some Amazon?
This is essentially what folks are doing in DeFi. And it’s why DeFi is incredibly popular.
We are essentially doing a proof-of-concept today with blockchain native cryptoassets.
Imagine what DeFi is going to look like when *all* assets are traded on blockchains?