Decentralized Finance (DeFi) is marvelous. No banks, no credit scores, just you and the blockchain. It is good for many purposes, including the one that many people require the most. Borrowing money. Sounds too good to be true, right? No. It actually works.
DeFi is shaking up traditional banking systems. At its core, DeFi offers financial services without the need for intermediaries.
It’s all powered by blockchain technology. And the tech miracles like smart contracts, but we will get back to that later.
Borrowing money in DeFi has become increasingly popular. Why? Because it provides access to liquidity without the usual red tape. People are turning to DeFi platforms to borrow assets using crypto as collateral. It’s fast, transparent, and often more accessible.
How’s so? Well, traditional banks require credit checks and lengthy approval processes. DeFi cuts through that with smart contracts and algorithms. In DeFi, your collateral is locked in a smart contract. This ensures security and trust without a central authority.
But it’s not all sunshine and rainbows, as you might have guessed already. DeFi borrowing comes with its own set of risks and complexities.
Understanding these risks is crucial before diving in. After all, we’re dealing with volatile assets and cutting-edge technology in its relatively early stages of development.
In this article, we’ll explore the top 10 things you need to know about borrowing money in DeFi. So, if you’re curious about how to leverage your crypto assets, keep reading.
Here's Your Ultimate Guide to Borrowing in DeFi in 10 easy steps.
1. Understand the Collateral Game
In DeFi, collateral is king. Pardon the inappropriate comparison, but It’s like the bouncer at the club – without it, you're not getting in.
Here's how it works: you deposit some of your crypto assets as collateral, and in return, you can borrow other assets.
Like, if you have a house, but want money to buy another house, you go to the bank and and mortgage the house to buy another one.
Simple, right? Well, not so fast.
The tricky part of DeFi borrowing is the loan-to-value (LTV) ratio. This is the percentage of your collateral's value that you can borrow. For example, if you deposit $1000 worth of ETH and the protocol has a 75% LTV, you can borrow up to $750.
But here's where it gets spicy – crypto prices are volatile. If the value of your collateral drops, your loan could get liquidated faster than you can say "to the moon."
That's why most DeFi protocols use over-collateralization. You're typically required to put up more collateral than you're borrowing. It sounds counterintuitive, but it's a safety net for the protocol.
And don't forget about the different types of collateral. Some protocols only accept major cryptocurrencies like ETH or WBTC. Others are more flexible, allowing you to use alt-coins or even NFTs.
Lastly, keep an eye on the collateral factor. This determines how much of each asset's value can be used as collateral. It varies between assets and protocols, so do your homework. Get acquainted with different DeFi services in advance before taking serious decisions.
2. Mind the Interest Rates
Now let’s find out the cost of borrowing in DeFi. Unlike your grandpa's bank loans, DeFi interest rates are a whole different ball game.
First off, DeFi interest rates are usually variable. They can change faster than a chameleon on a disco floor. Why? Because they're determined by supply and demand in the lending pool.
Here's the deal: when there's high demand for borrowing a particular asset, the interest rate goes up. When demand drops, so does the rate. It's like a never-ending auction.
But wait, there's more!
Some protocols use algorithmic interest rate models. These fancy mathematical formulas adjust rates automatically based on the utilization rate of the lending pool.
For example, Compound uses a model where rates start low when pool utilization is low, then curve upwards as utilization increases. It's like surge pricing for loans.
And don't forget about the difference between APR and APY. APR is the simple interest rate, while APY factors in compound interest. In DeFi, you'll often see crazy high APYs because of frequent compounding.
Some protocols also have a concept of "borrow APY." This is the effective interest rate you pay when you factor in the rewards you earn for borrowing.
Yes, you heard that right – some protocols reward you for borrowing!
DeFi is really a marvel. And, probably, a mere end to the traditional banking system. But not just yet.
3. Beware of Liquidation
Alright, time to talk about the boogeyman of DeFi borrowing – liquidation. It's the thing that keeps borrowers up at night, and for good reason. Especially, the beginners who are just paving their way through the DeFi open horizons.
Liquidation happens when the value of your collateral drops below a certain threshold. It's like a margin call in traditional finance, but on steroids.
Here's how it typically works. Let's say you borrowed $750 against $1000 of ETH (we’ve explained a bit earlier how loan-to-value works). If the price of ETH drops and your collateral is now only worth $900, you might get liquidated.
The liquidation threshold varies between protocols, but it's usually around 150% of the borrowed amount. Some protocols will liquidate your entire position, while others will only liquidate enough to bring you back above the threshold.
And here's the kicker – liquidations often come with a penalty. You might lose a percentage of your collateral on top of having your loan closed out.
But wait, it gets worse. In times of high market volatility, you might get liquidated even if the price only dips for a second. Yeah, it's that fast. Depends on the specific DeFi protocol, of course. But sometimes the play can be cruel indeed.
To avoid liquidation, you need to keep a close eye on your health factor. This is a metric that shows how close you are to liquidation. If it drops too low, you need to either add more collateral or repay part of your loan.
Some protocols are trying to be kind and user-friendly. They offer liquidation protection features.
For example, Aave has a "Health Factor" that gives you a buffer before liquidation.
MakerDAO allows you to set up automatic triggers to add collateral if you get too close to liquidation.
Remember, in DeFi, you're your own risk manager. There's no bank to call for an extension or to plead your case. Once you hit that liquidation threshold, it's game over.
4. Choose Your Protocol Wisely
Not all DeFi lending protocols are created equal. Some might be pretty unfriendly, especially to novice investors. Choosing the right one can mean the difference between smooth sailing and a financial shipwreck.
First up, let's talk about the big dogs.
Aave, Compound, and MakerDAO are like the holy trinity of DeFi lending. They've been around the block and have a track record of security.
But don't sleep on the newcomers. Protocols like Liquity and Alchemix are shaking things up with innovative features. Liquity offers interest-free loans, while Alchemix lets you borrow against future yields, a rather unique feature.
Security should be your top priority. Look for protocols that have been audited by reputable firms. Multi-sig wallets, bug bounties, and insurance coverage are all good signs.
Also, pay attention to the governance model.
Is it truly decentralized, or is there a small group calling the shots? This can affect everything from interest rates to protocol upgrades. Remember, DeFi isn’t supposed to be just a virtual bank. There is a philosophy of decentralization, and it is there for a reason.
Liquidity is another crucial factor. A protocol with deep liquidity pools means you're less likely to face high slippage or liquidity crunches.
Don't forget about user experience. Some protocols have slick interfaces that make borrowing a breeze. Others... not so much. If you're not comfortable navigating a complex DApp, you might want to stick with more user-friendly options.
Lastly, consider the ecosystem.
Some protocols integrate well with other DeFi services, opening up more opportunities for yield farming or leveraged strategies.
Remember, the "best" protocol depends on your specific needs. Are you looking for the lowest rates? The highest LTV? The most stable collateral options? Do your research and choose accordingly.
5. Understand the Risks
Alright, time for a reality check.
DeFi borrowing is complicated, it requires research and knowledge. And your better gain all those before you get into the game and may loose your funds.
There are some serious risks you need to wrap your head around.
First and foremost: smart contract risk. These protocols are only as secure as the code they're built on. Even with audits, there's always a chance of a bug or exploit. Just ask the folks who got rekt in the various DeFi hacks over the years.
Then there's oracle risk. DeFi protocols rely on oracles to get price data. If an oracle gets manipulated or fails, it could trigger unnecessary liquidations or other nasty surprises.
Don't forget about regulatory risk. The SEC and other watchdogs are starting to sniff around DeFi. A sudden regulatory crackdown could turn your borrowing strategy upside down. Chances are lower with a well established DeFi protocol, like Aave, Compound, and MakerDAO. But there are risky ventures that are better to be avoided. Once again, don’t be lazy and do a proper research before diving in.
Impermanent loss is another beast to watch out for, especially if you're using your borrowed funds for liquidity provision. It's like invisible inflation eating away at your gains.
And let's not forget about good old market risk. Crypto is volatile, and a sudden market downturn could send you straight to liquidation town.
There's also the risk of centralization. Some protocols have admin keys or upgradeability features that could be exploited if they fall into the wrong hands. Don’t entrust substantial amounts of tokens to a protocol that doesn’t appear to be a 100% trustworthy.
Lastly, there's you. Yes, you. User error is a major risk in DeFi. One wrong click, one misplaced decimal point, and poof – your funds could be gone forever. Do a proper reasearch, be well prepared, do not make emotional decisions.
6. Master the Art of Leverage
Let's talk about everyone's favorite DeFi party trick – leverage. It's like financial steroids, capable of amplifying your gains... or your losses.
Here's the basic idea: you deposit some collateral, borrow against it, then use the borrowed funds as collateral to borrow more. Rinse and repeat until you're leveraged to the gills.
Yes, that’s as complicated as playing chess, but the ones who know their game can win big time.
Some traders use their borrowed funds to provide liquidity or yield farm, potentially earning more than the interest they're paying. It's like borrowing money to make money. You might look at this in a slightly different light, if you remember how traditional banks are making money.
Anyway, there are DeFi protocols for playing this kind of games.
Platforms like dYdX and Fulcrum are built specifically for leverage trading. They let you take on leveraged positions with just a few clicks. It's like playing with financial dynamite.
You need to remember, leverage is a double-edged sword. While it can multiply your gains, it can also amplify your losses. A small price movement in the wrong direction can wipe out your entire position. You need to become a pro to play this game.
And don't forget about the cascading liquidations. In a market downturn, leveraged positions start getting liquidated, which drives prices down further, causing more liquidations. It's a vicious cycle that can turn a dip into a crash.
But DeFi is vast and diversified. Some protocols offer "flash loans" which let you borrow, use, and repay funds all in a single transaction.
These can be used for arbitrage or to unwind complex leveraged positions.
Remember, with great leverage comes great responsibility. Always use stop-loss orders and don't bet the farm on a leveraged position. And for the love of Satoshi, don't use leverage if you don't fully understand what you're doing.
7. Navigate the World of Stablecoins
In the wild world of DeFi borrowing, stablecoins are your best friend.
These tokens are made to always maintain their peg to a real world currency, most often to U.S. Dollar. They’re like the calm in the storm of crypto volatility.
Most DeFi lending protocols let you borrow stablecoins against your volatile crypto assets. It's a popular way to access liquidity without selling your precious BTC or ETH.
But not all stablecoins are created equal. You've got your centralized stablecoins like USDT and USDC, which are backed by real-world assets. Then there are algorithmic stablecoins like DAI, which maintain their peg through smart contracts and collateralization. There are also gold-backed (and gold-pegged) stablecoins (like PAX Gold).
Some protocols even let you mint their own stablecoins. MakerDAO's DAI is the OG here, but newer platforms like Liquity with its LUSD are joining the party.
Borrowing in stablecoins can be a solid strategy for avoiding liquidation risk.
Since the value of your debt doesn't fluctuate, you only need to worry about the value of your collateral. So half of your headache is now gone. Not to shabby.
But beware of de-pegging events. Even stablecoins can lose their peg in extreme market conditions. Just ask anyone who was holding UST during the Terra collapse.
Some protocols offer better rates for borrowing certain stablecoins. For example, you might get a lower interest rate for borrowing DAI compared to USDC on the same platform.
And don't forget about yield opportunities. Many DeFi protocols offer juicy APYs for providing stablecoin liquidity. It's a way to put your borrowed funds to work.
Lastly, keep an eye on the regulatory landscape.
Stablecoins are in the crosshairs of regulators worldwide. A crackdown could shake up the entire DeFi lending ecosystem. USDC, for example, is complying with recent new European laws, while USDT is under fire.
8. Explore Cross-Chain Borrowing
If you've read this far, you’re probably ready for more complex topic. Alright, strap in because we're about to go multi-dimensional.
Cross-chain borrowing is like DeFi on steroids, letting you access liquidity across different blockchains. While that may sound crazy, as we all get used to think in terms of solving problems within specific blockchains, it’s an amazing direction to move into.
Here's the deal: instead of being limited to borrowing assets on a single chain, cross-chain protocols let you use collateral on one chain to borrow assets on another.
It's like financial teleportation.
Platforms like THORChain and RenVM are pioneers in this space. They use clever cryptographic tricks to enable trustless cross-chain transactions.
But why bother with cross-chain borrowing? For starters, it opens up a whole new world of arbitrage opportunities. You can take advantage of price differences between chains without actually moving your assets. Clever trick, isn’t it?
It also allows for more efficient use of capital. Got some ETH but need some Solana-based tokens? No need to sell and rebuy – just use cross-chain borrowing.
Layer 2 solutions are getting in on the action too. Protocols like dYdX on StarkWare let you borrow with the security of Ethereum but with lower fees and faster transactions.
Of course, new horizons bring new challenges. Cross-chain borrowing adds an extra layer of complexity and risk. You're not just dealing with smart contract risk on one chain, but on multiple chains plus the bridging mechanism.
Interoperability is key in this space. Look for protocols that play well with others and have a track record of smooth cross-chain operations.
And don't forget about gas fees. While cross-chain borrowing can open up new opportunities, you need to factor in the cost of transactions on multiple chains.
Lastly, keep an eye on emerging standards like the Inter-Blockchain Communication (IBC) protocol. These could make cross-chain borrowing even more seamless in the future.
9. Maximize Your Borrowing Power
Here are some pro tips to squeeze every last drop of value out of your collateral.
First up: diversification. Don't put all your eggs in one basket. By spreading your collateral across different protocols, you can minimize the impact of a single liquidation event. The more assets you operate, the less are chances for them all to plummet simultaneously.
Next, learn to play the interest rate game. Some protocols offer better rates for certain assets or during certain times. Keep an eye out for these opportunities and be ready to move your loans around. Yes, DeFi borrowing game is a full time job of reading news, forums, social networks etc. As Oliver Stone told us with the sequel of Wall Street movie, the money never sleeps.
Collateral swapping is another nifty trick you should be aware of.
Some protocols let you switch out your collateral without closing your loan. It's like changing tires on a moving car – risky, but potentially rewarding. If you are good at your full time job (see above) you may be the first to sense that the storm is coming and it is time to jump of this specific asset.
Don't sleep on governance tokens. Many lending protocols reward borrowers with their native tokens. These can be sold for profit or used to participate in governance (and potentially vote for proposals that benefit borrowers).
Credit delegation is an advanced technique where you can borrow against someone else's collateral. It's like DeFi cosigning, but be careful – it requires a high level of trust.
Some protocols offer flash loan functionality. While primarily used for arbitrage, clever borrowers can use flash loans to rebalance their positions or avoid liquidation in a pinch.
Keep an eye on your health factor. As we mentioned above, this metric shows how close you are to liquidation. Some protocols offer tools to automate collateral additions if your health factor drops too low.
10. Stay Ahead of the Game
Here are some final advices you might find useful if you are seriously considering borrowing on DeFi.
First things first: education is key. The DeFi landscape is evolving faster than a chameleon on a disco ball. Make it a habit to read DeFi news, follow key developers on Twitter, and participate in community discussions on Discord or forums. Whatever time you are spending there now isn’t enough, double it.
Keep an eye on protocol upgrades. Many DeFi lending platforms regularly roll out new features or tweaks to their models. These changes could significantly impact your borrowing strategy. Once again, a habit of reading news on daily basis is essential.
Don't sleep on governance proposals. If you're heavily invested in a particular protocol, make sure you're aware of upcoming votes. A single proposal could change interest rates, collateral factors, or even fundamental aspects of how the protocol works. It’s a community, so be a part of it.
Be prepared for black swan events. The DeFi space has seen its fair share of hacks, exploits, and market meltdowns. Have a plan for what you'll do in case of such an emergency. This might include setting up alerts for sudden price movements or having a strategy for quickly exiting positions.
Consider using DeFi aggregators. Platforms like Zapper or Zerion can give you a bird's-eye view of your positions across multiple protocols. They can be a lifesaver when you're juggling multiple loans and collateral types.
Don't ignore the macro picture. DeFi doesn't exist in a vacuum. Keep an eye on broader crypto trends, regulatory developments, and even traditional finance news. All of these can impact DeFi borrowing markets. Read yellow.com on a daily basis, it’s good for you. No kidding.
Finally, don't get complacent. Just because a strategy worked yesterday doesn't mean it'll work tomorrow. Regularly review and adjust your borrowing positions to ensure they still align with your goals and risk tolerance. Don’t be afraid of experiments, just limit the amount of assets that be lost in case something goes awry.