What is DeFi lending and how does it work?

Since its introduction in 2017, Decentralized finance has not just gained global traction but has also arguably disrupted the financial industry with its unique features of programmability, immutability, interoperability, and transparency. Decentralized finance simply refers to digital assets, smart financial contracts, financial protocols, financial software, and decentralized applications based on blockchain technology, built to leverage the immutable, programmable, interoperable, transparent, and trustless features of blockchain to reshape finance into a system open to everyone without the need for central authorities like banks, financial intermediaries, and remittance/ cross border settlement institutions.

In the last paragraph, notice how I emphasized immutability, transparency, and trust. If there’s anything you should understand today, it should be that: although DeFi and CeFi seem similar, DeFi provides more features with lots of efficiency in financial transactions than CeFi. Decentralized finance allows two or more individuals or businesses to engage in financial transactions in an immutable, transparent and trustless fashion from any location in the world. All transactions happen on a blockchain, with every record immutable. I’ll explain it with this illustration below:

DeFi Lender A: Cash available to loan out: $100,000, He resides in New York and seeks to earn a 5% annualized yield on his cash, goes to a DeFi platform like Compound and deposits his cash in form of a digital asset like USDT or DAI to a borrower.

DeFi Borrower A: Digital asset worth $100,000 in Ethereum, resides in Taiwan and seeks to take a loan of $100,000 with a repayment plan of 5% annualized yield after 7 months, goes to Compound and also requests for this loan.

What happens is this, Compound serves as a user interface where the DeFi lender A and borrower A meet to execute this transaction on the blockchain, in a transparent way and without the rigors of traditional lending. Approximately 66% of the 1.7 billion people without bank accounts, according to the World Bank, also have a mobile phone. Decentralized finance aims to connect with these individuals in order to advance financial inclusion. The idea is to come up with a fairer version of traditional financial services, available online.

DeFi vs CeFi lending

While DeFi provides financial lending services without intermediaries via smart contracts, centralized financial institutions operate as transaction guarantors in the current financial world. DeFi lending simply replaces the financial institution with a smart contract hence reducing the risk of loss of financial assets by a hack, centralized malware, human error, centralized point of failure and more.

Also, decentralized finance lending provides speed of transactions, transparency, self-custody of assets, non-stop business transactions, low transaction fees, and no mandatory user verification. Decentralized finance lending continues to rely significantly on the long-standing traditional/ centralized financial system.

In summary, DeFi and CeFi lending have the same objective which is to provide high-quality financial goods and services to customers while also powering the global economy. Both CeFi and DeFi lending have their own drawback but integrating and adopting both features in finance is key to enhancing and reinventing global finance.

Thanks for reading.