Lending is a critical component of liquidity, which is at the heart of the majority of cryptocurrency markets and exchanges. One could argue that it is the lifeblood of the cryptocurrency money flow, as it provides the liquidity necessary for cryptocurrency exchanges to function. Without lending, trading different cryptocurrency pairs may result in extremely high slippage and fees, and certain small markets and exchanges may eventually cease to exist.

Historically, "lending" has been handled by traditional banks, institutional lenders, peer-to-peer lenders, and other money markets. Lenders earn money by charging interest on the capital they lend to borrowers. Financial institutions offer a variety of loan products, including certificates of deposit (CDs), repurchase agreements (Repos), commercial papers, treasury bills (T-Bills), and money market mutual funds.

You may not realise it, but if you have money deposited in a bank savings account, you typically earn a negligible annual interest rate because you are technically a "lender" and can earn interest on your deposited funds.

"Lending" can be facilitated in the cryptocurrency space via the CeFi (centralised finance) and DeFi (decentralised finance) protocols. The former entails lending your cryptocurrency to CeFi platforms, which are occasionally referred to as "crypto banks." The disadvantage is that they will retain full custody of your crypto assets throughout the lending programme, and you will be required to complete a KYC (know-your-customer) application. As such, it negates the entire point of cryptocurrency being decentralised, and additionally exposes you to hacking, insider trading, and bad loans.

This is why the majority of people prefer the latter as a more convenient and secure method of "lending." Individuals can lend out their cryptocurrency assets via DeFi protocols without submitting a KYC form or relinquishing custody of their tokens. Anyone with a cryptocurrency wallet can effectively participate in DeFi lending and borrowing – it's that simple.

DeFi protocols enable the creation of money market funds in a manner similar to that of traditional financial institutions, but completely digitally, permissionlessly, and automatically. Individuals interested in participating in this field must log into these DeFi platforms and exchange their tokens for interest. This interest, sometimes referred to as APY (annual percentage yield), is typically calculated automatically by an algorithm.

The entire lending process is automated; everything is built on the blockchain using algorithm-based smart contracts, which are transparent to all parties. Once you lend your tokens via the DeFi platform and smart contracts, the other side of the process kicks into gear, as borrowers now have access to both the supply tokens and interest.

What is the best way to use digital currency as collateral?

DeFi platforms enable you to borrow money using your existing digital currency, such as Ethereum (ETH). Why would you wish to do such a thing? For instance, suppose you are bullish on Ethereum over the long term and do not wish to liquidate your existing position, but you wish to participate in and trade high-flying tokens in the short term. You can borrow other tokens using your Ethereum as collateral. This way, you can keep your collateralized Ethereum while also having funds for other tokens.

Additionally, potential borrowers of any cryptocurrency on a DeFi platform must provide collateral before they can borrow tokens. The collateral's value is always greater than the amount to be borrowed. This concept eliminates bad loans by requiring borrowers to repay what they have borrowed, as the underlying collateral is worth more than the borrowed tokens.

What exactly is cryptocurrency loan liquidation?

However, given the volatility of the cryptocurrency markets, it is entirely possible that the collateral's value will eventually fall below the borrowed amount. When this occurs, you may become a victim of what is known as "crypto loan liquidation."

When borrowing crypto-backed capital, the borrower is required to provide collateral equal to the value of the crypto loan. Generally, the loan term is unlimited as long as the collateral value exceeds the loan amount. However, if the liquidation price of your crypto loan is breached to the downside, whether due to market volatility, a flash crash, a bear market, or for any other reason, your loan will be liquidated at the liquidation rate in order to ensure that all loan-related expenses are paid.

Keep an eye on liquidation rates whenever you take out a crypto-backed loan. You can avoid liquidation by depositing additional funds as collateral to cover the liquidation price, or by repaying the loan in full, plus interest.

Which decentralised lending platforms are the best?

As of 2021, the following are the top DeFi lending platforms:

Aave Protocol (AAVE)

The Aave Protocol is a completely decentralised lending platform built on Ethereum. Users can efficiently lend their crypto assets and earn interest on them using the blockchain's smart contracts algorithm. At $2.33 billion in market capitalisation, their native token, AAVE, is currently the 57th largest cryptocurrency.

Maker Protocol (MKR)

This is one of the earliest DeFi platforms, focusing on the management of the cryptocurrency market's largest stablecoin, the DAI. By locking in their DAI tokens, which are pegged to the US dollar, users can earn interest on their savings rate contract. Maker's governance token, MKR, enables holders to vote on protocol upgrades such as adding new collateral assets, modifying collateral risk parameters, altering the DAI savings rate, and so on.

Compound Finance (COMP)

Compound Finance is a September 2018-launched lending protocol. Users can participate in their open lending platform by depositing and earning interest on their Ethereum tokens. With a market cap of $1.179 billion, their native token, COMP, is the 83rd largest cryptocurrency. Additionally, it is a governance token, which means that holders of the token have the ability to vote on protocol changes – for example, changes to collateralization levels or other policy changes.

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