Earning returns in decentralized finance (DeFi), also called yield farming, is one of the most common goals of web3 newbies.
It makes sense: If you like crypto, why not earn some extra tokens while you’re at it? Lending protocols are one of the most popular ways to earn those returns.
In this article, we’ll show you how DeFi lending works and introduce 2 protocols you can use to earn a return on your crypto.
Ready? Let’s dive in!
How DeFi Lending Platforms Work
DeFi lending platforms are automated, blockchain-based protocols where you can lend and borrow cryptocurrencies. They basically work like banks: You give them your tokens, they loan them to others with interest and send you (part of) the proceeds.
But while a bank rents offices, operates branches, employs thousands of people and incurs many other expenses, lending protocols do much of that via smart contracts. This cuts expenses and needed head count to a fraction, which leaves a higher return for depositors.
Here are a few key characteristics of DeFi lending:
- Lending is peer-to-peer: Users borrow from each other, not from the protocol.
- Loans are approved by smart contracts, usually based on collateral provided.
- Lending and borrowing rates are determined algorithmically.
DeFi Lending Protocols
DeFi lending protocols, also called liquidity protocols, are the rules encoded within the smart contracts governing DeFi platforms.
They automate the process of matching lenders and borrowers, setting interest rates based on supply and demand and enforcing the terms of loans, thereby ensuring a seamless and secure lending/borrowing process.
DeFi Lending vs. Staking
Both DeFi lending and staking offer ways to earn passive income from crypto holdings. However, they differ in their approach. DeFi lending involves supplying crypto assets to a lending platform where borrowers can take loans against them.
In contrast, staking involves participating in the network of a Proof-of-Stake (PoS) based blockchain by locking up tokens to earn rewards.
In practice, staking and lending are similar: You give your tokens to a smart contract. You can’t move them for a while, but withdraw them later with additional tokens.
But there are a few key differences:
- To solve the problem of unavailability, protocols like Lido and Rocket Pool invented liquid staking, which gives you a liquid staking token you can trade with—while still earning staking rewards.
- Staking locks your token up while depositing it on a liquidity protocol lends it out to others. In practice it feels the same, but the technical background is different.
Staking also has the risk of getting slashed if the node validates faulty transactions. As the article linked above explains, liquid staking can also create risks of centralization.
Why not both? Combining DeFi lending and staking
When you give your ETH to a smart contract, it leaves your wallet. That means you can’t increase your returns by staking ETH and giving the same ETH to a lending protocol.
But liquid staking protocols give you what’s called a liquid staking derivative, which is another token. That means you can deposit your staked ETH on a lending protocol like Aave. While the lending APYs on liquid ETH from Rocket Pool and Lido are usually low, this is an example of how to combine DeFi strategies to maximize your returns.
Need some stablecoins, ETH or other tokens? A DeFi loan is a decentralized, collateralized loan where borrowers lock up crypto assets to borrow cryptocurrencies. This is like taking out a mortgage backed by your house: If you fail to repay the loan, the bank repossesses your house. The same happens with collateral provided on DeFi platforms like Aave or Compound: You put up some tokens which are seized if you don’t pay back your loan.
These loans are over-collateralized, which means borrowers provide collateral worth more than the borrowed amount to mitigate default risk. While DeFi is always speculative because of the volatility of crypto assets, overcollateralization has made DeFi lending platforms some of the more resilient DeFi protocols.
While the crash of 2022 exposed the weaknesses of many protocols and brought them to their knees, most lending platforms are still doing well.
An Exception: DeFi Flash Loan (Without Collateral)
A flash loan, pioneered by lending protocol Aave, is a unique DeFi feature, permitting users to borrow funds without collateral. The only condition is that the loan must be returned within the same transaction block.
They’re focused on developers and require technical expertise to execute, so we won’t dive too deeply into them in this guide.
These are very technical and enable complicated use cases. The most common flash loan use case is for arbitrage: If Uniswap quotes a higher price for ETH than the lending protocol, traders might get a flash loan to pocket that difference on a trade.
These are highly speculative and risky strategies, so proceed with caution, even if you have the technical knowledge.
Aave & Compound:
The Leading Lending Protocols
There are many lending protocols, but two dominate the market: Compound and Aave. Both protocols are similar, but have some unique features:
Aave, which started as ETHLend in 2017, is a leading DeFi lending protocol that allows users to lend, borrow, and earn interest on crypto assets. Unique features of Aave include uncollateralized flash loans, rate-switching (between stable and variable rates), and the ability to delegate credit to other users.
Compound is another prominent DeFi lending platform. It allows users to supply and borrow crypto assets directly with the protocol. Compound popularized the concept of liquidity mining, where users are rewarded with COMP governance tokens for interacting with the protocol.
Compound vs. Aave
While both Aave and Compound offer similar services, there are noteworthy differences. First, rates and tokens offered differ between the two protocols. While you’ll rarely find big differences between Aave’s and Compound’s lending and borrowing rates, it’s worth comparing them.
Aave provides more flexibility to borrowers with features like flash loans and rate-switching, while Compound's liquidity mining model appeals to yield farmers.
That being said, the differences are narrowing—Aave has also launched their governance token $AAVE and both protocols now offer token holders to create and vote on proposals for the future of the protocol.
If you’re exploring Ethereum, check out Fire!
DeFi lending platforms like Aave and Compound are reshaping the way we earn interest on investments, allowing for a more open and accessible financial system. While promising high returns, users should be aware of the associated risks such as smart contract vulnerabilities and price volatility. As with all financial ventures, thorough research and due diligence are crucial for success in the DeFi lending space.