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How does loan in Defi work and what types of loan exist?

Until recently, individuals wishing to borrow money could only do so through centralized financial institutions such as banks or accredited credit institutions. However, the traditional banking system is quite conservative and relies on the credit history of the customer to assess the creditworthiness of the user. Consequently, people without a credit history are often not able to get their first loan because they do not have the data the bank needs.

Fortunately, the rapid growth of start-ups and DeFi companies has solved this problem by introducing a more flexible and forward-looking lending system. The decentralized finance industry is slowly gaining influence in the global lending arena. However, people seeking credit should be aware that DeFi loans work differently. In this article, we look at how these loans work, what types of loans are available, and the benefits and risks to be aware of before taking out a DeFi loan.

How DeFi loans work

DeFi loans work on the principle of using blockchain technology and smart contracts to facilitate lending and borrowing without the need for intermediaries. This decentralized approach offers many advantages, such as increased accessibility, transparency and efficiency.

The DeFi lending process typically involves the following steps:

Collateral. Borrowers must provide collateral, usually in the form of digital assets, to secure their loans. The collateral acts as a guarantee for lenders, reducing the risk of default. This ensures that lenders will have recourse in the event of non-payment.

Smart contracts. Smart contracts, self-executing agreements recorded on the blockchain network, play a key role in DeFi lending. These contracts contain predefined rules and conditions that govern the lending process, including loan terms, interest rates and collateral requirements. Through the use of smart contracts, the lending process becomes automated and uncontrolled, as transactions are carried out based on predefined conditions.

Execution of the loan. Once the borrower satisfies the terms of the collateral, the smart contract automatically executes the loan by transferring the agreed funds to the borrower's address. At the same time, the collateral is held in escrow under the smart contract until the loan is repaid.

Rates of interest and repayment. Borrowers are usually required to repay the loan with interest within a certain period. Interest rates are often determined by supply and demand dynamics within the loan platform, creating a competitive environment. Failure to repay the loan within the agreed time frame can lead to liquidation of the collateral.

DeFi loans vs Traditional loans

Traditional loans involve a centralized body, such as a bank, acting as an intermediary between borrowers and lenders. This entails various constraints, including lengthy approval processes and credit checks. In contrast, DeFi loans eliminate the need for intermediaries, allowing for a more inclusive lending environment.

In addition, DeFi loans allow borrowers to access funds quickly and conveniently because the process is automated and operates around the clock. Traditional loans often require a lot of paperwork and are subject to bank hours and deadlines.

Let's compare loan processing at a traditional lending institution and DeFi loans.

Parameters info	Traditional loans	DeFi loans
Credit history	Needed	Isn’t needed
Level of confidentiality	Low. The bank asks for proof of identity. In this case, information about the client may be stored in its database for years.	High. Many decentralized protocols allow users to remain anonymous.
Speed of processing	Low. It takes time to check documents and analyze the client's credit risks. In some cases, it takes more than a day for a loan approval decision to be issued.	High. You can get a loan in a few minutes.
Accessibility	Low. Banks are selective in choosing clients for a loan. Bad credit history and other nuances can be a reason for refusal.	High. Almost anyone can get a loan in the decentralized protocol.
Profitability	Low. Traditional banks charge high interest rates.	High. DeFi's loan offers benefit from low interest rates.

Types of DeFi loans

DeFi has many types of loans for different customer needs. Let's look at some of the common types of loans in DeFi.

Secured loans. These loans require borrowers to provide collateral that exceeds the value of the loan. This collateral acts as a guarantee for the lenders, ensuring that they will be able to recover their funds in case of default. Cryptocurrencies, stablecoins and other digital assets are usually used as collateral. Secured loans give borrowers the advantage of access to larger loan amounts, often at better interest rates.

Unsecured loans. Unlike secured loans, they do not require collateral. Instead, the borrower is evaluated based on his or her creditworthiness, reputation, and other factors. Such loans are more risky for the lenders. Consequently, unsecured loans often have lower lending limits and higher interest rates than secured loans.

Flash loans. Flash loans are a unique and innovative type of loan in DeFi that allows borrowers to access funds without prior collateral. These loans originated in a single transaction and require borrowers to repay the loan in the same transaction. Flash loans are mainly used for arbitrage opportunities or other complex financial transactions, and they rely heavily on immediate repayment of borrowed funds. If repayment fails, the entire transaction is unwound.

P2P loans. Peer-to-peer (P2P) loans in DeFi allow individuals to lend and borrow directly from each other, eliminating the need for intermediaries. P2P lending platforms link borrowers and lenders through smart contracts, facilitating trust-free transactions.

P2P loans can be secured or unsecured, depending on the agreement between the parties. Such loans often offer flexible terms and competitive interest rates.

It is important to note that the availability and features of these types of loans may differ across DeFi platforms. Borrowers should carefully examine the terms and risks of each type of loan.

Advantages of DeFi loans

Loans in DeFi have a number of advantages that make them attractive to borrowers and lenders alike. Let's take a look at some of the key advantages:

Global accessibility. DeFi loans are available to anyone with an internet connection, regardless of their geographical location. Such a feature opens up opportunities for people who can't take advantage of traditional banking services.
Permission-free lending. These loans work on blockchain networks without approvals, allowing borrowers to receive them without the need for approval from intermediaries.
Transparency and security. All loan transactions in DeFi are recorded in blockchain, providing transparency for all parties involved. In addition, the use of smart contracts provides a high level of security, as loan terms are automatically fulfilled — reducing the risk of fraud or default.
24/7 availability. Unlike traditional banking systems with limited opening hours, DeFi is available around the clock, seven days a week. Borrowers can access funds and make loan transactions at any time.
Competitive interest rates. Borrowers can get a loan at better interest rates than traditional lending institutions.
Self-sufficient loans. In DeFi, borrowers are able to receive funds against their existing deposits, which are already generating income for them. This means that the loan itself can be partially or fully covered by the income generated by the borrower's deployed assets, thereby reducing the repayment burden. All DSF users have the possibility to get such a loan.

Risks of DeFi loans

While DeFi loans offer many benefits to users, it is important to be aware of the potential risks associated with them as well. Here are some of the main concerns:

Smart contract risk. DeFi credits rely heavily on smart contracts, which are programmable code executed on a blockchain. However, they are not immune to vulnerabilities or bugs. If a smart contract contains a flaw or exploit, it could lead to financial losses for the borrower. It is important to examine the code and security audits of the smart contracts involved in the lending process and choose platforms with a solid reputation.
Liquidity risk. During times of high market volatility or periods of low liquidity, borrowers may find it difficult to obtain loans or experience delays in loan processing. Also, sudden changes in liquidity can affect borrowing rates.
Market risk. DeFi loans are secured by digital assets that are subject to market fluctuations. If the value of the collateral drops significantly, it may lead to liquidation or require additional collateral to maintain the loan-to-value (LTV) ratio.

The DeFi lending market is in many ways superior to what traditional banks offer. However, loans in the decentralized finance segment are still far from the volume of transactions handled by classical lending institutions.

One of the reasons why DeFi lags behind is the skeptical attitude of users towards the market opportunities. Among other things, the level of popularity of decentralized finance has been negatively affected by frequent protocol hacks and low levels of liquidity. It can be assumed that in the future DeFi will strengthen security and outperform the classic credit market.