In the old days, we used banks and other financial institutions to lend and borrow. If we wanted a loan, we’d go to the bank who would assess our suitability and potentially offer a loan. Similarly, if we wanted to lend our assets contacting a bank or broker would be in order.
Decentralized finance (DeFi) improves on this system by offering the same products peer-to-peer. This cuts out intermediary institutions who charge fees, act as gatekeepers, and are liable to corruption.
DeFi achieves this by using smart contracts. When someone lends or borrows using a DeFi protocol, they sign an immutable smart contract that governs the terms of the transaction (including interest paid and earned). If someone wants to alter the contract they first have to fulfill the terms of the contract, close it, then open a new one.
There are currently hundreds of billions of dollars locked in DeFi smart contracts. People like it because it’s decentralized, there are no gatekeepers or background checks, and it’s open to anyone 24 hours a day. Better still, interest rates are higher than those offered by traditional financial services.
DeFi uses over-collateralized loans to create a safe lending environment while protecting privacy and anonymity. For example, if you deposit $10,000 worth of Bitcoin, you will only be allowed to borrow up to $7,500 worth of crypto.
Over-collateralization protects against volatility in crypto markets. If the price of Bitcoin dives and becomes less than the loan amount, the borrower will need to top up their account or their funds will be automatically liquidated.
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