DeFi lending protocols differ from banks in that the whole protocol is entirely on-chain and not controlled by any centralised entity. This means that the difference between the lending and borrowing rates can be significantly smaller than in traditional finance, as the whole process runs much more efficiently on smart contracts without overhead through human intermediaries.
We should note that there are also centralised lending and borrowing companies in crypto, which also offer better returns than traditional banking due to the increased efficiency of dealing with cryptocurrencies rather than fiat. However, this still requires you to trust the companies and to undergo KYC (Know Your Customer) checks, revealing your identity. In DeFi, on the other hand, you only need to trust that the smart contract is well written and doesn’t contain any bugs, and you can borrow or lend crypto without revealing anything except your public wallet address.
Compound and Aave
To explain how lending and borrowing work, we can take the example of Compound and Aave, currently the two most popular protocols. Both work similarly when it comes to borrowing: a user deposits collateral into the protocol (in the form of a particular token) and receives a loan in another token. When the user pays back the loan plus interest, the collateral is returned to them.
Due to the volatility of crypto, DeFi loans are always overcollateralised. This means that, for example, if you want to borrow 1000 USDT with ETH as collateral, you may need to deposit 1250 USD worth of ETH. It is very important to maintain the minimum collateralisation ratio, or the loan will be at risk of liquidation.
So why would one take out a loan if they have to deposit more in collateral than the loan is worth (rather than just selling the collateral)? The main reasons are that a user needs funds at a particular time in order to deal with some unforeseen event, or that they’re bullish on the collateral token and don’t want to sell it. In some jurisdictions, there are also tax benefits of taking out a loan compared to selling crypto.
When it comes to lending, the basic principle of Compound and Aave is the same, but it is implemented differently. In both cases, the user supplies an asset to the protocol, and that asset is then used for loans. In return for the tokens supplied, the protocol issues new tokens which represent the supplied asset plus interest (and which can be transferred just like any other token). When these tokens are returned, the user receives the underlying asset plus interest for the time that it was supplied.
The main difference between Compound and Aave is the ratio between the supplied tokens and the tokens that the user receives (these are called cTokens in Compound and aTokens in Aave). In Compound, the exchange rate gradually increases over time (e.g., the user receives 500 cETH tokens for 1 ETH, and upon redeeming them a year later, they receive 1.1 ETH for their 500 cETH tokens due to the change in exchange rate). In Aave, aTokens are issued and redeemed at a 1:1 ratio to the supplied tokens, and the protocol rewards interest by continually increasing the user’s aToken balance.