With interest rates at or near all-time lows across the developed world, the search for yield has become increasingly difficult for investors. Long gone are the days of being able to park your money in a term deposit that pays seven-plus per cent interest per annum. One alternative that yield-seeking investors have recently started turning to has been made possible thanks to smart contracts and the blockchain technology upon which they run.
Decentralised finance—or DeFi, as you have likely heard it referred to as—is a term that describes a number of decentralised protocols building open financial infrastructure. One of the use cases in DeFi that has seen the most traction to date is lending. That is, users are depositing (i.e., lending) their cryptoassets into a smart contract—which has been designed for a specific protocol—and earning interest for doing so. For the most part, these users’ cryptoassets are then borrowed for the sake of margin trading (i.e., a method of trading assets where you use funds that are provided by a third party).
The interest rates offered through these DeFi protocols are significantly higher than what you can get for investing your money in term deposits or government bonds. Of course, choosing to lend to a DeFi protocol is not without its risks—more on this later—but because of the relatively high interest rates on offer, it is at least worthwhile knowing what the best DeFi lending platforms are. And so, without further ado, let’s dive in!
Built on Ethereum, Compound is an algorithmic money market protocol that lets you earn interest or borrow cryptoassets against collateral. When you supply your cryptoassets on Compound, you receive so-called cTokens. These are ERC-20 tokens—meaning you can transfer, trade, or send them to cold storage—that represent your balance in Compound.
As your cTokens accrue interest—on Compound, interest rates are a function of the liquidity available in each market and fluctuate in real-time based on supply and demand—they become convertible into an increasing amount of its corresponding cryptoasset.
It is important to distinguish the Compound protocol—which has been described above—from the Compound Interface. The Compound Interface is a user-facing application that allows you to directly interact with the smart contracts that underpin the Compound protocol. There continues to be more apps and interfaces—such as Coinbase Wallet, Dharma, Argent, InstaDapp, and Huobi Wallet—plugging into the Compound protocol.
dYdX is an Ethereum-powered non-custodial exchange for margin trading and eventually derivatives. You can use dYdX to trade, borrow, and lend any supported cryptoasset. dYdX was the first of the DeFi lending and borrowing solutions to natively support trading (i.e., you do not have to leave dYdX to execute margin trades).
By depositing your cryptoassets on dYdX, you will earn interest every second and are able to withdraw your funds at any time. The interest you earn is paid by other dYdX users who are borrowing the same cryptoasset that you have deposited. With dYdX, you are not required to register an account nor do you need to trust a centralised party with your cryptoassets—because they are managed and stored on the Ethereum blockchain using smart contracts.
Powered by bZx—a decentralised protocol built on Ethereum that enables lending and borrowing for margin trading—Fulcrum is a front-end web interface that allows you to lend funds to a cryptoasset pool that borrowers can use to margin trade. In return, these borrowers pay interest into the cryptoasset pool which has the effect of increasing its value.
When you decide to withdraw your funds, you are entitled to a proportional amount of the interest that the corresponding cryptoasset pool has accrued. Withdrawing your funds is achieved by selling a so-called iToken on Uniswap or an exchange. An iToken is a representation of your funds in the cryptoasset pool and the interest that you funds have accrued.
Nuo is a decentralised debt marketplace that connects lenders and borrowers through Ethereum-based smart contracts. Like dYdX and Fulcrum, Nuo features a built-in margin trading platform. You can lock up cryptoassets with Nuo and be compensated by earning a daily amount of interest.
The mechanism through which you do this on Nuo is by creating a so-called debt reserve, which you can create for a cryptoasset of your choice for a specific duration. Then, when the debt reserve expires, the cryptoasset you locked up and the interest accrued is automatically transferred from Nuo’s debt reserve smart contract to your Nuo account. It’s also possible to withdraw funds—with interest—at any stage prior to the debt reserve’s expiration date.
Proceed With Caution
It is imperative for you to understand that there are a number of risks associated with exposing your own capital to DeFi lending protocols. One of the greatest risks pertains to smart contract vulnerabilities. If a flaw in a smart contract is exploited by a malicious actor, it could lead to devastating financial losses for users of a DeFi protocol. Whilst smart contract auditing tooling is always improving, it does not guarantee that every single smart contract bug will be detected ahead of time.
Somewhat related, another risk involved with lending on DeFi platforms is its reliance on intermediary third parties known as oracles. In DeFi, smart contracts rely on an oracle to source market data (e.g., the spot price of token [x] at [y] point in time). Encouragingly, there are many teams working on creating a secure oracle system. Additional risks, pain points, and uncertainties surrounding the DeFi lending space concern areas of custody, regulation, taxation, and insurance.
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