Robin Kim graduated from New York University in 2015 with a degree in economics. He borrowed over $100,000 from the US government and quickly found himself pegged to high interest rates. Since then, he has been trying to pay off his student loans.
In the end, Kim refinanced through a private lender to lower the interest rate, but he wondered if there was another way. “I paid $1,500 a month, every month, to pay off this loan,” he says. “This amount could have been better spent elsewhere.”
Former Coinbase engineer and co-founder Gallery, an online platform that people can use to collect and exchange their NFT collections, Kim considered selling cryptocurrencies to pay off his loans. But if he did, he would have to pay taxes on any profits he made.
Instead, Kim took out a loan through lending platform called Aave, built on the Ethereum blockchain. He used the money to pay off his debt and is now working on paying off a new loan.
How do DeFi loans work?
Decentralized finance is a general term for blockchain applications used to create complex financial products. Since DeFi loans are not tied to the traditional banking system, they sometimes have lower interest rates, do not affect the borrower’s credit score, and can theoretically be held indefinitely.
DeFi loans can be based on any digital currency. This includes stablecoins, which are cryptocurrencies whose value is pegged to external sources such as the US dollar. In order to take out a DeFi loan, borrowers must first collateral in the form of cryptoassets in excess of the amount they wish to borrow. How much more depends on the percentage set by the lender. It’s like investing $100 in one currency to borrow $75 in another.
The borrower receives a loan, for example, in stablecoins, which can then be exchanged for US dollars. This money is used to pay off the debt, and then the borrower eventually repays the DeFi loan to pay back the collateral.
However, the benefits of DeFi come with risks. The borrower’s collateral may be liquidated if its value falls below the value of the loan. Bitcoin, despite having more market liquidity than any other cryptocurrency, still very changeable, fluctuating in value by an average of 3% per day. If prices fall too much, borrowers lose collateral. (Although if the price of collateral rises, this risk is lower.)
Stablecoins have also been the focus of government scrutiny, given the risks of an unregulated stablecoin market for the global economy. Regulators warned that possible price fluctuations could lead to massive losses for stablecoin holders and destabilize the entire financial market.
In November 2021, a US government task force recommended that Congress require stablecoin issuers to be subject to the same rules as banks. In February, U.S. Representative Josh Gottheimer, Democrat of New Jersey, announced Law on innovation and protection of stablecoins, which will issue government insurance for stablecoins. These moves will reduce the risk of volatility, but the government-backed coin will no longer be decentralized.
Another major risk is that smart contracts, automated loan agreements on the blockchain, are not infallible. Smart contracts are executed based on predefined conditions written in code. This code is written by people and mistakes, bugs or hacks can confuse borrowers.
A matter of trust
Therefore, borrowers must trust the platform issuing their loan. More established platforms may take security measures to mitigate risk. For example, platform Treasury of the complexThe community has hired security firms to evaluate his credit protocol to make sure his code is secure.
“However, in reality, the end user, developer and borrower or lender should really appreciate the stability and riskiness of a smart contract,” says Reid Cuming, Compound vice president and general manager. “I think we’re still in a state where there’s a lot of room for improvement here.”
Anyone who knows your wallet address can see how much you have borrowed.
DeFi platforms also provide a bit of privacy for borrowers.which means that anyone who knows your wallet address can see how much and when you borrowed.
Crypto skeptic Molly White says this divides users into three camps: people who protect their privacy by being able to use major crypto platforms, people who give up some privacy to use them, and people whose identities and crypto wallets are publicly linked. .
As the choice of platforms boils down to liquidity and privacy, many of the supposed benefits of decentralization—privacy, anonymity, and independence from corporations—are no longer valid. And managing these risks requires technical expertise that most borrowers simply don’t have.
On the one hand, White says, some believe that these platforms carry out financial transactions that were once the prerogative of experts, accessible to everyone“But, on the other hand, people are drawn into making risky decisions for which they do not have the knowledge to be able to make them responsibly.”
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Kim remains optimistic. He compares the situation to the early days of the Internet and says that even with the risks, DeFi could become mainstream. “I think DeFi will achieve parity with centralized finance… just because of its transparency and openness,” he says. “The ecosystem needs to mature, but I think that applies to any new technology.”