DeFi: Beyond Fintech and Banks

“It is not the strongest of the species that survives, nor the most intelligent; it is the one most adaptable to change.” — Charles Darwin

For decades, banks have been the financial institution to borrow money and get extra passive income (interest from deposits). However, the recent popularity of P2P (Peer-to-Peer) lending started to bother the incumbents. P2P lending platform offers convenience, speed, and better margin that are absent in traditional banking systems, yet it raises a new concern: privacy. Can DeFi (Decentralized Finance) be a solution to the modern financial system?

The Emergence of P2P Lending

Humans survive because we go through countless adaptations, yet we are always reluctant to change. We embrace unfamiliar territory only if the old practice is incapable to satisfy current demand or new option offers much better than the old one.

For decades, the bank is the institution to borrow or get extra passive income (interest). However, the fame of P2P lending in millennials and gen-z recently may give clue on how the traditional financial system cannot suffice modern demand.

Peer-to-peer (P2P) lending offers an alternate platform to conduct loan agreements through an electronic system (internet). P2P lending organization eliminates conventional intermediaries by directly connect lender and borrower. Almost all interactions and procedures occur in a single app. P2P lending has a different mechanism from traditional banking (see figure 1).

Figure 1: Lending Process in Bank vs P2P Lending (Thakor,2020)

P2P lending eliminates many administration steps, which makes it faster and more convenient for both lender and borrower. When groceries, packages, and food are delivered into people’s houses in mere hours, people see convenience and speed as a basic requirement not privilege anymore. Therefore, banking procedure which often takes days or even weeks became troublesome. The Elimination of physical location and replacement of humans with algorithms cut down operating costs. Thus, the P2P margin between lending and borrowing can be compressed, giving the users more of their money.

In Indonesia, P2P lending organizations might act as passive or active platforms. A passive platform means the organization mainly provide a platform for lender and borrower to meet. For example, Investree is a platform where lenders and borrowers can meet directly. The borrower will upload all the documents needed. Lenders will do their own due diligence to pick the loan.

An active P2P lending organization means it is actively involved in the lending process. For example, Asetku is a self-operated P2P lending platform. Lender in Asetku will be financing borrowers from consumers and merchants of Akulaku.

Figure 2: Asetku Lending Scheme (Akulaku,2019)

Asetku does not match a lender to a borrower 1:1. Instead, money deposited from lenders will be pooled together. The sophisticated algorithm from Asetku will assets the credit rating and diversifies loans to several borrowers. The lender will never know who is the borrower and the detail of the lending process (see figure 2).

However, Asetku put minimal requirements to borrow money: age above 17 years old and proof of bank account. To prevent fraud and high bad debts, Akulaku (sister company of Asetku) uses powerful and holistic risk management (see figure 3). The company uses massive data collection and cutting-edge algorithms to minimize the default risk even with the price of violating the user’s privacy.

Figure 3: Akulaku Risk Management (Akulaku, 2019)

If we pause for a second, people attracted to P2P lending is because of its convenience, speed, and margin. What if we can P2P’s benefits without sacrificing the user’s privacy? Meet Aave.

Aave

Aave is open-source decentralized finance (DeFi) protocol for lending and borrowing cryptocurrency without a central intermediary. Aave has the largest total value locked (TVL) $15b, hence we use it as a case study. Aside from Aave there are many lending protocols, such as Compound, Alchemix, Maker, and etc.

In DeFi, there is no central organization. Instead, smart contracts intermediate the lending process. A smart contract is a set of computer codes that run automatically. The protocol uses a decentralized autonomous organization (DAO); meaning everything is operated and governed by the AAVE token holders.

How Aave Works?

Lenders or in Aave called depositors earn interest for providing liquidity, while borrowers can borrow cryptocurrency. The system is not matching a depositor to a borrower 1:1. Depositors' assets will be pooled together (like P2P lending Asetku). Therefore, the lender will never know the borrower. To make sure of the liquidation, the borrower must always overcollateralize. Meaning if a lender wants to borrow 100 USDT, the lender needs to have collateral 120 USD worth of Ethereum (ETH). Is this a crazy scam? Why do people want to borrow less money than their own collateral? Wait, please imagine this example:

Let say you put 120 USD worth of ETH and get a stable coin worth 100 USD. You use the 100 USD for few months and want to pay back your ETH. By then ETH has double the price, so now you pay back (100 USD stable coin + interest) and cash out ETH worth 200 USD. However, this is a double-edged sword because if the price of ETH dropped to a certain level, Aave will automatically sell your collateral to cover your loan (will explain more below). This way, depositors will never lose money. Figure 4 explained to complete process of lending in Aave.

Figure 4: Process Lending-Borrowing in Aave (khangky,2021)

Figure 4 explanation:

1: Depositor deposits asset in Aave pool and receives aToken of 1:1 (1 ETH will get 1aETH)
2: Borrower deposits collateral asset to borrow the asset. The borrower needs to maintain a healthy position to avoid liquidation.
3: Depositor can redeem the aToken with the original asset deposited. The aToken will increase according to the interest paid by the borrower.
4. Borrower can close the debt position by returned the borrowed assets plus interest.

In here, there is no limit time when to paid back the loan. The period of the loan is determined by HF (Health Factor). It represents the safety of the borrowed asset and its collateral. The decrease of HF is not only because of the decline in collateral price but also because the value of borrowed assets increases. If you borrow a stable coin, you might only concern about the collateral value. But if you borrow other assets (LINK, ETH, AAVE, etc), you have to care about collateral and borrowed value. If the HF drops to less than 1, the borrower can repay the loan or deposit more collateral. However, as long as the HF is healthy, the borrower has unlimited time to pay back.

How to use Aave?

Let’s talk about the interest rates. Most of the rates in Aave are floating depending on supply and demand, but the borrower can choose the stable rate. Figure 5 provides the APY (Annual Percentage Yield) rate for borrowers and depositors. Aave’s APY rate fluctuates according to supply and demand (a). The depositors and borrowers can see the 30 days average of APY (b). The borrower also can get a fixed rate (c).

Figure 5: Aave Rate (Aave, 2021)

Flash Loans

Most of the loan in Aave is overcollateralized, but Flash Loans allows borrowers to borrow any available amount of asset without any collateral, as long as the liquidity is returned to the protocol within one block transaction. However, you need to understand coding because you need to build a smart contract requesting a flash loan. The contract will be executed according to instructed steps and pay back the loan + interest and fees all within the same transaction. People usually use Flash loans to:

  • Arbitrage between assets without collateralized the principal
  • Swapping collateral of loan positions

The flash loan fees are 0,09% of the borrowed volume for the flash loan, all going to the depositors.

Risk of Aave

There is some risk associate about DeFi protocol mainly related to security and regulation. Due to open-source protocol, the safety of your money depended on the security codes. If there is a hack or breach, it will be very difficult to restore the money. However, Aave is the most audited DeFi protocol (9 audit organizations). For now, just like other protocols in cryptocurrency, DeFi also has little regulation.

In conclusion, the emergence of P2P lending proves how traditional banking has failed to suffice current modern demands: convenience, speed, margin. However, P2P lending organizations raise a new issue: privacy. DeFi (Decentralized Finance) can solve both problems in traditional banking and P2P lending. Even though DeFi may still be far from perfect, it might be the solution that the modern financial system needed.

Sources:
Thakor, A. V. (2020). Fintech and banking: What do we know? Journal of Financial Intermediation, 41. https://www.sciencedirect.com/science/article/abs/pii/S104295731930049X?via%3Dihub.
Akulaku. (2019). Akulaku Management Presentation. https://assets.mintos.com/5413B1F4-9415-97FB-ACBC-F50953AB61D3.pdf.
(n.d.). https://defipulse.com/aave.
khangky. (2021, July 13). How It Works #02 | Aave (AAVE) | Lending platform for institutional? coin98insights.com. https://coin98insights.com/how-it-works-aave.
Keman, O. (2021, June 16). Aave: The Future of Banking. https://medium.com/coinmonks/aave-the-future-of-banking-a465190c4938#:~:text=Instead of traditional banks raking,loans are in a minute.
(n.d.). https://docs.aave.com/risk/audits/summary.