Lending And Borrowing In DEFI Explained - Aave, Compound

Summary

The video explains decentralized finance (DeFi) lending and borrowing protocols like Aave and Compound. It covers how lenders supply assets to earn interest while borrowers lock collateral to take loans, with interest rates set algorithmically based on supply and demand. It details the risks and incentives around overcollateralized loans. Finally, it compares the variable rate models of Compound and Aave, noting Aave's added stable rate option, and advises users to monitor rapid rate changes that could trigger liquidations.

Takeaways

• 💻 Lending and borrowing in decentralized finance (DeFi) is facilitated through smart contracts, allowing users to lend or borrow assets without a central authority.
• 🔑 DeFi lending platforms like Aave and Compound create money markets for various tokens, enabling users to supply tokens to earn interest or borrow against their holdings.
• 💰 Interest rates in DeFi lending are determined by the supply and demand dynamics within each platform's ecosystem, with rates being variable and calculated per Ethereum block.
• 🧱 Most DeFi loans are over-collateralized, requiring borrowers to provide more value in tokens as collateral than the amount they are borrowing, to mitigate the risk of default.
• 💸 Compound and Aave offer unique features; Compound uses cTokens for interest accrual, while Aave offers stable borrow rates and flash loans, highlighting the diversity in DeFi lending solutions.
• 📈 The collateral factor in DeFi lending dictates how much a user can borrow based on the value of their collateral, affecting the borrowing limits and the risk of liquidation.
• 💳 Centralized finance (CeFi) platforms like BlockFi operate similarly to traditional banks but are prone to the same risks, such as hacking or mismanagement of funds.
• 💵 DeFi lending platforms aim to offer an alternative to traditional and centralized finance by providing transparency, security, and accessibility without requiring personal information.
• 🛠 Smart contract risks and rapidly changing interest rates pose significant challenges in DeFi, requiring users to stay informed to avoid potential liquidations or losses.
• 💹 Aave's introduction of stable APYs and flash loans, alongside Compound's dynamic interest accrual mechanism, showcases the innovation and user-centric features available in DeFi lending.

Q & A

What are the two main elements of any financial system that lending and borrowing enables?

Lending and borrowing enables the two main elements of any financial system - lenders providing funds to borrowers in return for interest on their deposit.

How does decentralized finance (DeFi) lending allow users to participate in lending and borrowing?

DeFi lending allows users to become lenders or borrowers in a completely decentralized and permissionless way, while maintaining full custody over their coins through smart contracts.

What are the two main DeFi lending protocols mentioned in the script?

The two main lending protocols available in DeFi mentioned are Aave and Compound. Both create money markets for tokens like ETH, stablecoins, and other cryptos.

Why would a user want to take a loan by supplying collateral worth more than the loan amount?

Reasons include not wanting to sell their tokens but needing funds for expenses, avoiding/delaying capital gains taxes, or using the borrowed funds to increase leverage on a position.

How are interest rates determined in DeFi lending protocols?

Interest rates are determined by the ratio between supplied and borrowed tokens in a market. Rates can change dramatically depending on lending/borrowing demand.

What is the main difference between Compound and Aave when it comes to interest rates?

The main difference is that Aave offers stable interest rates in addition to variable rates like Compound. Stable rates are fixed short-term.

How does supplying and borrowing assets on Compound work?

Users deposit tokens to Compound and get cTokens which accumulate interest. cTokens can be used as collateral to borrow other tokens. Borrowed assets accrue interest paid to lenders.

What risk comes with the concept of overcollateralized loans in DeFi?

If asset prices drop, borrowers can get liquidated by having to repay more than expected as their collateral value falls below the loan amount.

How does Compound determine how much a user can borrow?

Compound uses a smart contract that calculates borrowable amount based on collateral across a user's account without risking immediate liquidation.

What are the main risks of decentralized finance lending?

Risks include smart contract risks and quickly changing interest rates potentially causing liquidations.

Outlines

00:00

😊 Introducing decentralized lending and borrowing

The paragraph introduces the concepts of lending and borrowing, explaining how they work traditionally through financial institutions and how decentralized finance protocols like Aave and Compound enable lending and borrowing while maintaining custody of assets. It compares centralized crypto lending by companies like BlockFi to decentralized alternatives, highlighting the risks of centralized services and the permissionless, transparent nature of DeFi lending powered by smart contracts.

05:00

😮 How borrowing limits and interest rates are determined

This paragraph explains how borrowing limits and interest rates are calculated in DeFi lending. Borrowing power depends on the collateral factor of supplied assets and available liquidity in each market. Interest rates for lenders and borrowers are variable based on supply and demand dynamics. Aave offers stable rate lending to reduce rate volatility. Reasons for borrowing despite overcollateralization are also discussed.

10:01

👨‍🏫 An example explaining Compound cTokens

An example is provided to demonstrate how Compound's cTokens work. A user supplies 10 ETH and receives cETH representing claim on the ETH plus accumulated interest. As the cToken exchange rate increases with each block, users can redeem cTokens for more ETH than they initially supplied, earning interest. The example shows how a 0.16% APY on ETH supply could be achieved over 1 month as cETH exchange rate rises.

Keywords

💡Lending and borrowing

The main financial activity focused on in decentralized finance (DeFi). It allows users to lend out their crypto assets to earn interest or borrow assets from pooled liquidity. This is done through smart contracts without centralized intermediaries. Key platforms mentioned are Compound and Aave.

💡Money market

A part of the traditional financial system that enables short-term lending and borrowing of assets. Similar functionality is replicated in DeFi through lending protocols like Compound and Aave which create money markets for crypto assets.

💡Supply APY

The annual percentage yield earned by suppliers of crypto assets to DeFi lending platforms. Determined algorithmically based on the ratio between supplied and borrowed assets in each market.

💡Borrow APY

The annual percentage yield that borrowers must pay when borrowing assets from DeFi lending platforms. Tends to be higher than Supply APY.

💡Collateral factor

The percentage of a supplied crypto asset's value that can be borrowed against it. Important for calculating how much users can borrow while avoiding liquidation.

💡Exchange rate

The rate at which supplied crypto assets can be redeemed for interest-bearing tokens like cTokens in Compound. Increases automatically with each new block to account for accrued interest.

💡Liquidation

When a user's collateral drops below a minimum threshold required to back their borrowed amount, resulting in the automatic seizure and sale of their assets to repay debts.

💡Smart contract risks

Despite removing counterparty risks, DeFi still carries risks inherent to the smart contract code that governs lending protocols. Bugs or flaws could compromise user funds.

💡APY volatility

Due to algorithmic determination of rates, lending/borrowing yields in DeFi can fluctuate wildly based on changes in supply/demand dynamics. Unexpected rate spikes could liquidate overleveraged positions.

💡Trustless

A key ethos in DeFi - requiring no trusted intermediaries or centralized parties to facilitate financial activities. Enabled by smart contracts running transparently on blockchain.

Highlights

Introduction to lending and borrowing in DeFi, highlighting its importance in financial systems.

Explanation of traditional lending and borrowing through financial institutions versus DeFi platforms.

Comparison between centralized finance (CeFi) companies like BlockFi and Celsius, and DeFi protocols like Aave and Compound.

Discussion on the risks associated with centralized lending such as hacks and negligence.

Advantages of DeFi lending including decentralization, permissionless access, and self-custody of assets.

Detailed overview of how Aave and Compound function as leading DeFi lending protocols.

Explanation of over-collateralization in DeFi lending and the rationale behind it.

Factors determining how much can be borrowed in DeFi, including available funds and collateral factor.

The mechanism of interest rates in DeFi lending, highlighting the variable interest rates determined by supply and demand.

The unique features of Aave, such as stable borrow interest rates and flash loans.

In-depth example of how Compound's cTokens work, demonstrating the process of earning interest on deposited assets.

Comparison of Aave's aTokens to Compound's cTokens and their respective interest accumulation models.

The procedure for borrowing in DeFi using collateralized tokens and the implications of liquidation.

How DeFi platforms manage price feeds and assess collateral value to ensure loan security.

Discussion on the risks of DeFi lending, including smart contract vulnerabilities and fluctuating interest rates.

Transcripts

so have you ever been wondering how

landing and borrowing works in d5

how are the supply and borrow rates

determined and what is the main

difference between the most popular

lending protocols

such as compound and other we'll answer

all of these questions in this video

before we begin if you want to learn

more about decentralized finance

and the technology behind it make sure

you subscribe to my channel

you can also check out our free guide to

defy that i will link in the description

box below

let's start with what lending and

borrowing is lending and borrowing

is one of the most important elements of

any financial system

most people at some point in their life

are exposed to borrowing

usually by taking a student loan a car

loan

or a mortgage the whole concept is quite

simple

lenders aka depositors provide funds to

borrowers

in return for interest on their deposit

borrowers

or loan takers are willing to pay

interest

on the amount they borrowed in exchange

for having a lump sum of money

available immediately traditionally

lending and borrowing is facilitated by

a financial institution

such as a bank or a peer-to-peer lender

when it comes to short-term lending and

borrowing the area of traditional

finance

that specializes in it is called the

money market

the money market provides access to

multiple instruments

such as cds reapers

treasury bills and others in the

cryptocurrency space

landing and borrowing is accessible

either through dsi protocols

such as ave or compound or by c5

companies

for instance blockfi or celsius

c5 or centralized finance operates in a

very similar way to how banks operate

this is also why sometimes we call these

companies

crypto banks blockfy for example

takes custody over deposited assets and

lends them out

to either institutional players such as

market makers or hedge funds

or to the other users of their platform

although the centralized lending model

works just fine

it is susceptible to the same problems

as centralized crypto exchanges

mainly losing customer deposits by

either

being hacked or other forms of

negligence

you can also argue that the cifi model

basically goes against one of the main

value propositions of cryptocurrencies

self-custody of your assets this is also

where defile landing comes into play

defy lending

allows users to become lenders or

borrowers

in a completely decentralized and

permissionless way

while maintaining full custody over

their coins

define lending is based on smart

contracts that run

on open blockchains predominantly

ethereum

this is also why defile landing in

contrast to c5 landing

is accessible to everyone without a need

of providing your personal details

or trusting someone else to hold your

funds

ava and compound are two main lending

protocols available in d5

both of the protocols work by creating

money markets

for particular tokens such as eth

stable coins like dye and usdc or other

tokens

like ling or wrapped btc users

who want to become lenders supply their

tokens to a particular money market

and start receiving interest on their

tokens according to their current supply

api

the supply tokens are sent to a smart

contract and become

available for other users to borrow in

exchange for supply tokens

the smart contract issues other tokens

that represents the supply tokens plus

interest

these tokens are called c tokens in

compound

and a tokens in ava and they can be

redeemed for the underlying tokens

we'll dive deeper into their mechanics

later in this video

it's also worth mentioning that in d5 at

the moment

pretty much all of the loans are over

collateralized

this means that the user who wants to

borrow funds

has to supply tokens in the form of

collateral

that is worth more than the actual loan

that they want to take

at this point you may ask the question

what's the point of taking a loan

if you have to supply tokens that are

worth more than the actual amount of the

loan taken

why wouldn't someone just sell their

tokens in the first place

there are quite a few reasons for this

mainly the users don't want to sell

their tokens

but they need funds to cover unexpected

expenses

other reasons include avoiding or

delaying paying

capital gain taxes on their tokens or

using borrowed funds

to increase their leverage in a certain

position

so is there a limit on how much can be

borrowed

yes the amount that can be borrowed

depends on two main factors

the first one how much funds are

available to be borrowed in a particular

market

this is usually not a problem in active

markets unless

someone is trying to borrow a really big

amount of tokens

the second one what is the collateral

factor of supply tokens

collateral factor determines how much

can be borrowed based on the quality of

the collateral

dai and eth for example have a

collateral factor of 75 percent on

compound

this means that up to 75 percent of the

value of the supply die or

heat can be used to borrow other tokens

if a user decides to borrow funds the

value of the borrowed amount

must always stay lower than the value of

their collateral

times its collateral factor if this

condition holds

there is no limit on how long a user can

borrow funds for

if the value of the collateral falls

below the required collateral level the

user

would have their collateral liquidated

in order for the protocol

to repay the borrowed amount the

interest

that lenders receive and the interest

that borrowers have to pay

are determined by the ratio between

supplied and borrowed tokens

in a particular market the interest that

is paid by borrowers

is the interest earned by lenders so the

borrow api

is higher than the supply api in a

particular market

the interest apis are calculated per

ethereum block

calculating apys per block means

that define lending provides variable

interest rates

that can change quite dramatically

depending on the landing and borrowing

demand for particular tokens

this is also where one of the biggest

differences between compound and other

comes in

although both protocols offer variable

supply and borrow apis

ave also offers stable borrow api

stable apy is fixed in a short term but

it can change in the long term

to accommodate changes in the supply

demand ratio

between tokens on top of stable apy

ave also offers flash loans where users

can borrow funds with no upfront

collateral

for a very short period of time one

ethereum transaction

more on the flash loans here to better

understand

how the defile lending protocols work

let's dive into an example

but before we do that if you made it

this far and you enjoy the video

hit the like and subscribe buttons so

this kind of content can

reach a wider audience let's dive deeper

into the mechanics of compound

and c tokens in our example a user

deposits 10 heath into compound in

exchange for 10eth

compound issues c tokens in this case

c if how many c tokens will the user

receive

this depends on the current exchange

rate for a particular market

in this case ether when a new market is

created

the exchange rate between c tokens and

underlying tokens

is set to 0.02 this is an

arbitrary number but we can assume that

each market starts at 0.02

we can also assume that this exchange

rate can only increase

with each ethereum block if the user

supplies 10 eth

when the market was just created they

would have received

10 divided by 0.02 equals

500 ces because the ether market

has been operating for a while we can

assume that the exchange rate is already

higher

let's say it's 0.021

this means that the user would receive

around

476.19

ces if the user decided to immediately

redeem their ease

they should receive roughly the same

amount as it was deposited

which is around 10 eat now here is when

the magic happens

the user holds their ces this is just

another erc20 token

that can be sent anywhere the main

difference

is that ces is necessary to redeem the

underlying heath from compound

on top of that seat keeps accumulating

interest even if it's sent from the

original wallet

that initiated the deposit to another

wallet

with each ethereum block the exchange

rate would increase

the rate of the increase depends on the

supply apy

which is determined by the ratio of

supplied borrowed capital

in our example let's say that the

exchange rate from c

to 8 increases by this amount with each

block

assuming that the rate of increase stays

the same

for a month we can easily calculate the

interest

that can be made during that time let's

say on average we have four blocks per

minute

this gives us the following numbers

now we can add this number to the

previous exchange rate

and get the following number that is

slightly higher than the previous

exchange rate

if the user decides to redeem their ease

they would receive

around 10.0165 each

so the user just made 0.0165

each in a month which is around 0.16

return on their eath it's worth noting

that the original amount of ces that the

user received

hasn't changed at all and only the

change in the exchange rate

allowed the user to redeem more eth than

was initially deposited

ave uses a similar model with interest

being accumulated

every single block the main difference

is that

a token's value is packed to the value

of the underlying tokens

at the one-to-one ratio the interest is

distributed to a token holders

directly by continuously increasing

their wallet balance

a token holders can also decide to

redirect their stream of interest

payments

to another ethereum address when it

comes to borrowing

users lock their c tokens or a tokens

as collateral and borrow other tokens

collateral earns interest but users

cannot redeem or transfer assets

while they are being used as collateral

as we mentioned earlier

the amount that can be borrowed is

determined by the collateral factor

of the supplied assets there is also a

smart contract

that looks at all the collateral across

user's account

and calculates how much can be safely

borrowed

without getting liquidated immediately

to determine the value of collateral

compound uses its own price feed that

takes prices

from several highly liquid exchanges

other

on the other hand relies on channeling

and falls back to their own price feed

if necessary if a user decides to repay

the borrowed amount

and unlock their collateral they also

have to repay

the accrued interest on their borrowed

assets

the amount of accrued interest is

determined by the borrow

api and is also increased automatically

with each ethereum block different

lending although reducing a lot of risks

associated with centralized finance

comes with its own risks mainly the

ever-present

smart contract risks but also quickly

changing apis

for example during the last yield

farming craze

the pro apy on the bat token went up to

over 40 percent

this could cause unaware users who are

not tracking compound interest rates

daily

to get liquidated by having to repay

more than

expected in the same period of time so

what do you think about landing and

borrowing in detail

and what is your favorite platform

comment down below

and as always if you enjoyed this video

smash the like button

subscribe to my channel and check out

the cinematics on patreon

to join our defy community thanks for

watching