With interest rates around all-time lows, investors’ hunt for yield has become increasingly tough. Long gone are the days of being able to park your money in a term deposit that pays seven per cent interest per annum.
One alternative yield-seeking investors are turning to has been made possible thanks to smart contracts and the blockchain technology upon which they run.
Decentralised finance (DeFi) is a term that describes a number of decentralised protocols building open financial infrastructure. The vast majority of these are built on the Ethereum blockchain.
One DeFi use case that’s growing in popularity is lending. That is, crypto owners are depositing (i.e. lending) cryptocurrencies into Ethereum-based smart contracts. And in return, they’re earning interest.
What happens with these cryptocurrencies once deposited? Mostly, they go to borrowers for the sake of margin trading. (Margin trading is a method of trading assets where you use funds that are provided by a third party.)
The interest rates offered through these Ethereum-based DeFi protocols are a lot higher than term deposits and government bonds. Of course, lending to a DeFi protocol is not without risk. More on that later. But because of the relatively high interest rates on offer, it’s at least worth learning about the more popular DeFi lending platforms.
Built on Ethereum, Compound is an algorithmic money market protocol that lets you earn interest or borrow cryptocurrencies against collateral. When you lend cryptocurrency on Compound, you receive so-called cTokens. These are Ethereum-based ERC-20 tokens that represent your balance in Compound. cTokens are tradable and transferrable.
As cTokens accrue interest, they become convertible into an increasing amount of its corresponding cryptocurrency. (On Compound, interest rates are a function of the liquidity available in each market and fluctuate in real-time based on supply and demand.)
It’s important to distinguish the Compound protocol described above from the Compound Interface. The Compound Interface is a user-facing application that allows you to directly interact with the Compound protocol’s smart contracts. There continue to be more apps and interfaces—such as Coinbase Wallet and Argent—plugging into the Compound protocol.
dYdX is a non-custodial exchange or margin trading and eventually derivatives. You can use dYdX to trade, borrow, and lend any supported cryptocurrency. dYdX was the first of the DeFi lending and borrowing solutions to natively support trading. That means you don’t have to leave dYdX to margin trade.
By depositing your cryptocurrency on dYdX, you’ll earn interest every second. Also, you can withdraw your funds at any time. The interest you earn is paid by other dYdX users who are borrowing the same cryptocurrency that you’ve deposited.
(Note, dYdX is built on a standalone blockchain that is based on the Cosmos SDK and Tendermint proof-of-stake consensus protocol. It no longer runs on Ethereum. Read the dYdX’s announcement for more details.)
DeFi Lending Risks
It’s imperative for you to understand that there are a number of risks associated with exposing your own capital to DeFi lending protocols. One major risk is smart contract vulnerabilities. If a flaw in a smart contract is exploited, it could lead to devastating financial losses for DeFi protocol users. Smart contract auditing tooling keeps improving, but it doesn’t guarantee that all smart contract bugs will be detected ahead of time.
Another risk involved with lending on DeFi platforms is its reliance on intermediary third parties known as oracles. In DeFi, smart contracts rely on an oracle to source market data (e.g. the spot price of token [x] at [y] point in time). Encouragingly, many teams are working on creating a secure oracle system.
Additional risks, pain points, and uncertainties surrounding the DeFi lending space concern areas of custody, regulation, tax and insurance.