Lending protocols aims to offer crypto loans in a trustless manner. There are several types of lending primitives with a variety of secondary protocols built on-top of it.
How the protocol works is very simple. Depositor deposit crypto into the protocol to earn interests. Borrowers can borrow funds from the protocol and pay an interest when returning the loans. The liquidity of the borrowed funds will stem from the liquidity provided by the depositors.
In order to ensure that the loans will be returned, borrowers typically need to put down a collateral that is of equal value as the loans. And if the loans are not repaid, the borrower’s collateral assets will be liquidated to cover the loss. These loans are therefore not the undercollateralized loans we typically see at traditional banks and are typically used for leveraging and opening short positions.
Nonetheless, from the depositor’s point of view, it still works the same way: deposit currency and earn interests. The interests will be determined by the utilization ratio, which is how much and how long the underlying asset is borrowed. This makes sense as the interests depositors earn comes from borrowers repaying their loans, and if the borrowers borrow more and for a longer period of time, the depositors should naturally earn more.
Flash loan is a powerful tool & interesting concept which does not exist in traditional finance. Borrowers do not need to deposit any form of collateral at all and it is a type of undercollateralized loans. Flash loans does sounds to good to be true, and hence there is a caveat. And that is flash loans needs to be return within one transaction block, else the loan never happened.
In blockchains, transactions are bundled into a block and validated. Transactions that are not validated into blocks are simply pending transaction that has yet to happen. Therefore, from the protocol’s point of view, a flash loan is simply a special kind of loan where it is immediately return after borrowed. And in the event that the loan is not repaid, the earlier transaction that borrows the loan simply fails and does not get included in the block, which means the loan never took place!
However, flash loans does seem to have very little utility if it has to be repaid in a single transaction. Typical usage of flash loans is limited to moving liquidity such as arbitraging, collateral conversion, farm changing, etc. And in the case of profit opportunities, it will be even more limited as we are unlikely to see much price movement in a block duration. This is also the reason why flash loans are more popular on older blockchains that have longer block durations and deeper liquidity such as Ethereum.
Stablecoin protocol is another important aspect to lending primitives. Similar to lending protocols, depositors deposit collateral into the protocol, and in exchange they get to mint stablecoins based on the amount of their deposits. In the event the amount of collateral falls below the circulating value of stablecoin, the protocols has to buy back & burn the stablecoins it has minted.
In the older models, stablecoins rely on arbitragers to maintain the stablecoin peg. Such examples are Terra, Acala, Maker where the peg hovers around $1 depending on the arbitragers. There are also variations such as Frax Finance and Ampleforth which takes on mixed approaches such as relying on other existing stablecoins and rebasing techniques.
This also led to invention of reserved currencies where the price of the asset is free floating despite the collateral backing underneath. The history, evolution & drama of reserved currencies is noted to be the most exciting events in the world of crypto and we will discuss it in detail in another article.
P2P loans protocol is essentially an inefficient application of non-custodial liquidity markets where the liquidity cannot be shared across borrowers and lenders. This can be beneficial when the assets is under-utilize where it would be more capital efficient for lenders to source higher interests. Although it would require effort to search for borrowers, lenders do not need to share their profits in the pooled liquidity.
With the rise of NFTs, P2P loans are becoming more popular as NFTs by itself is an illiquid asset. P2P loans allow NFT holders to hedge against their NFTs and bring liquidity to their assets.
NFTs are still in an infant phase at this stage and liquidity is still very fragmented. Hence, we would not be able to see well-defined APR at this point of time compared to mature lending markets.
With the existence of liquidation mechanism in lending primitives, it brings about the Cambrian explosion of financial derivatives. Margin trading, options, perpetuals, leveraged tokens all rely on the liquidation mechanism to achieve leverage, liquidation, funding and settlements.
Take for example auto-settlement of on-chain crypto options. During a call option expiry, the price of the underlying cryptocurrency will be compared against the strike price. If the strike price is lower than the price of the underlying asset, the option can be exercised automatically. A loan is first borrowed to exercised the option, upon receiving the underlying asset, the underlying asset is then sold and used to repay the loan. Any remaining excess will then be kept as profits for the option buyer.
There are of course also protocols that directly utilize the entire lending protocols to achieve leverage farming and all sorts of automated trading strategies.
For example, with leveraged lending we can achieve pretty high APR of over 100% on initial launch of the protocol in a new chain. While it is not sustainable in the long run, it is still pretty generous compared to existing lending protocols on mainstream Defi on Ethereum.
And with Defi & NFT space booming, we are bound to see more interesting derivatives becoming mainstream and the eventual phasing out of simple primitives.