Borrow-lending is one of the fundamental pillars of both TradFi and DeFi markets. Before using DeFi lending products, it is important to understand some the fundamental principles and terminology of borrow-lending.
Broadly speaking borrow-lending can be categorized into two buckets – under- and overcollateralized lending:
<aside> 💡 When you buy a house, you typically put up a deposit of 10-30% of the value of the house and take the rest as a mortgage. If the value of the house is USD 100,000 and you have put up an initial deposit of USD 20,000, that means that you borrowed [100,000 – 20,000 =] USD 80,000 from the bank, and used the USD 100,000 house as collateral.
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Undercollateralized lending is generally available in a setup where there is a mechanism in place to enforce the rights of the lender, i.e. a legal system that should ensure borrowers repay their undercollateralized loans or otherwise manage the default process. As DeFi has not yet developed a mechanism that would prevent users from acting maliciously - creating new wallets, taking out undercollateralized loans and disappearing - DeFi borrow-lending is overcollateralized.
Collateral: Assets provided by the borrower as security for the loan. If the borrower defaults, the lender can claim the collateral. Collateral acts as a guarantee to the lender that the borrower will fulfill their loan obligations. In the event of default, the lender has the right to seize the collateral to recover the loan amount.
Loan-to-Value (LTV) ratio: Calculated as loan amount divided by collateral value. Lower LTV means a safer loan for the lender.
<aside> 💡 If we take the housing example above, the starting LTV of the mortgage would be [80,000 / 100,000 =] 80%. If the value of the house doubles, LTV would decrease to [80,000 / 200,000 =] 40%, and if the value of the house halves, the LTV would increase to [80,000 / 50,000 =] 160%.
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Fixed vs Variable interest rates: Fixed rates remain constant, while variable rates fluctuate based on certain conditions. In DeFi, pool-to-peer lenders have variable interest rates which depend on utilization of the pools – the higher the utilization, the higher the interest rate.
APY vs APR: APY (annual percentage yield) includes compounding interest, whereas APR (annual percentage rate) does not.
<aside> 💡 For example, a 5% monthly return translates to a 60% APR (you receive 5% each month, taking out the profits each month, for 12 months) but an 80% APY due to compounding (after receiving 5% after the first month, you reinvest this interest back, so your first month’s income now also generates 5% each following month, and so on). While this difference might not seem like much, if we take an example with a higher interest, which you can often see in DeFi, and assume you are getting 5% per week – APR would be 260%, while APY would be a whopping 891%!
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It is therefore important to appreciate the optics that APY can create, especially if you are intending to compound the returns of if the product does not allow for it – you might be misled into thinking you are generating significantly more returns than you actually are.
Liquidation: The process of selling the borrower’s collateral if its value drops below a certain threshold (liquidation threshold) to repay the loan.
<aside> 💡 A simple example here would be if a company takes out a 40% LTV loan from a bank against a portfolio of $250 of publicly traded shares, i.e. a [40% * 250 =] $100 loan with a liquidation threshold of 75%. If the value of the shares locked in collateral decreases to [100 / 75% =] $133.33, the bank can force sell the collateral shares and use the proceeds to repay the loan, returning the remainder to the borrower – this is called a liquidation.
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