Since emerging, decentralized finance (DeFi) has revolutionized finance by providing accessibility and control. Crypto lending is one of the most critical use cases in DeFi, enabling crypto holders to lend and borrow assets without intermediaries, thus democratizing access to financial services.
The privileged position of lending protocols in DeFi is underlined by the three most prominent players in this subsector: Aave, JustLend and Compound. Together, these platforms boast over $12 billion in total value locked (TVL) — about 23% of DeFi’s overall TVL of $50 billion as of mid-July 2023. These numbers demonstrate the immense potential and interest in decentralized lending.
Nevertheless, DeFi lending still faces critical challenges. The two main concerns are overcollateralization and the high risk of liquidation. These problems seem imminent due to the innovative nature of DeFi lending, which bypasses the traditional system at the cost of sacrificing its safeguards.
In DeFi, lenders can take advantage of yield opportunities to seek generous returns, which makes the sector attractive. However, the flip side is not so bright for borrowers. They have to pledge a higher value of collateral than the loan amount they receive, which exposes them to more significant risks.
This approach results from the decentralized and noncustodial nature of DeFi lending, which lacks traditional financial assessments such as credit scores or proof of income to assess a potential borrower’s risk profile. Finally, DeFi loans are overcollateralized — borrowers may only get 50% or 60% of the value of the assets they’ve locked up as collateral.
Futures and perpetual contracts provide users the ability to obtain more of the collateral threshold, but the
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