What Are Decentralised Lending Protocols?
Decentralised lending protocols fundamentally change the situation. Unlike traditional finance, where banks and other institutions act as intermediaries, decentralised lending protocols remove the middleman. It is a concept built into blockchain technology in which financial services such as lending, borrowing, trading and investing are governed by smart contracts - self-executing contracts whose terms are written directly into the code.
Decentralised lending has its roots in Bitcoin, the first widely used digital currency. However, it was only after the launch of Ethereum in 2015 that the real potential of decentralised lending protocols began to unfold.
The Ethereum network gave developers the ability to build decentralised applications (DApps) capable of automating complex financial activities. Since then, these DApps have evolved into a wide range of services, from decentralised exchanges (DEX) to lending platforms, all operating without a central authority.
Smart contracts, DApps and the blockchain itself are the core building blocks of decentralised lending protocols. Smart contracts are the foundation that allows agreements to execute without human intervention.
DApps are the user-facing tools that interact with these contracts, offering services similar to those found in traditional banking, but without the usual barriers to entry. Blockchain, and Ethereum in particular, functions as a transparent, tamper-resistant ledger in which every transaction is recorded permanently.
Decentralised lending protocols open the door to financial services without requiring an intermediary, a physical branch, or identity checks tied to a bank account. Anyone can inspect the code behind these protocols, which is a sharp contrast to the closed-off practices of traditional banks. In addition, they operate continuously and without downtime, offering a level of availability and efficiency that traditional systems simply cannot match.
This also makes decentralised lending protocols particularly attractive to people who want to put their capital to work without the usual paperwork and regulatory friction associated with traditional finance.
How Do Decentralised Lending Protocols Work?
Decentralised lending protocols have expanded the range of ways investors can put digital assets to work, making unique and creative combinations for earning passive income possible.
Looking at how they actually function, decentralised lending protocols are built on blockchain technology and run on established networks such as BNB Chain and the Ethereum network. These networks remove the need for an intermediary by relying on a decentralised peer-to-peer (P2P) financial infrastructure.
This allows users to supply funds, borrow, and access deep liquidity. As a result, yields can be higher than at licensed financial institutions such as banks, since there is less overhead built into the process.
In a centralised financial system, your funds sit with institutions such as banks, which exist primarily to generate profit. Within that system there are a number of third-party checkpoints that a transaction has to pass through.
At each checkpoint, these third parties confirm the transfer of funds from one side to the other and charge a fee for the service.
Decentralised lending gives individuals, entrepreneurs and companies the ability to carry out financial transactions directly, with the support of modern technology, removing the need for intermediaries in the financial system.
To do this, peer-to-peer financial connections are built using advances in networking, software and hardware, along with security protocols.
You can trade, lend and borrow with the support of software that records and verifies financial activity on a shared ledger accessible from anywhere, as long as you have an internet connection.
Decentralised lending protocols use this technology to move away from rigid, centralised financial models, giving anyone access to financial services no matter where they are.
How to Invest in Decentralised Lending Protocols with 8lends
If you're considering putting money into digital assets, there are a few points worth focusing on before you make a decision about decentralised lending.
Given that the decentralised lending space is now crowded with thousands of digital asset projects, it can be difficult to work out which investments are suited to long-term growth and which are better suited to short-term activity.
For example, if a digital asset promises minimal risk alongside an outsized reward, that is, more often than not, a sign of a scheme with no long-term viability.
It is generally sounder to invest in highly liquid protocols, ones with large communities of developers and users, along with independent research that supports the methodology used to assess the risks of the assets the protocol lets you work with.
Why Do Decentralised Lending Protocols Matter?
Through personal digital wallets and trading tools built specifically for individual users, decentralised lending applications give people a high degree of control over their financial assets. Their underlying database relies on blockchain technology, the same technique that underpins Bitcoin.
Blockchain allows multiple parties to jointly maintain a record of transactions, without that record being tied to a single central authority.
This matters because centralised systems and human gatekeepers have every opportunity to slow down or complicate transactions, and to give users less direct control over their own funds. Decentralised lending protocols are unique in that they extend the use of blockchain beyond simple currency transfers into far more sophisticated financial applications.
The core idea behind Bitcoin as a form of digital money has been built upon and expanded by decentralised lending protocols, leading to fully digital versions of traditional finance, but without many of the fees usually attached to it. This has the potential to create more transparent financial markets.
Platforms for Generating Passive Income
Let's look at a few of the best decentralised lending protocols for generating passive income.
Aave (AAVE) - Aave is one of the most widely used and well-established decentralised lending protocols in the space.
To start using Aave, users deposit a digital asset in the amount they choose. Because these funds are then made available to borrowers, depositors earn passive yield based on market demand.
The platform also lets users borrow funds, using their deposit as collateral. In addition, it rewards users based on their participation in the protocol with its native asset, AAVE.
Synthetix (SNX) - Synthetix is a fast-growing protocol that allows users to mint synthetic assets known as “synths”.
The platform lets users trade digital assets for synthetic representations of stocks, currencies, commodities and other assets. Although it runs on the Ethereum blockchain, it gives users exposure to fiat currency, derivatives and other assets alongside digital ones.
Users can take a position on the value of an asset without actually owning it in order to earn a profit, which has made it one of the more popular protocols in the space.
Curve (CRV) - Curve Finance is a decentralised exchange platform built for swapping USDC and other dollar-pegged digital currencies, as well as wrapped Bitcoin.
Users can supply deep liquidity in dollar-pegged digital currencies to Curve's protocols and earn passive yield from trading fees.
The fees generated from swaps on the exchange are distributed to users in proportion to the liquidity they have supplied.
What Are the Risks?
While decentralised lending protocols open up wide-ranging opportunities, they also come with risks. Smart contract vulnerabilities, market volatility and regulatory uncertainty are among the key risks involved.
That's why diversifying your investments, staying informed, and using reputable platforms to reduce these risks is essential. The risks include:
Security
Decentralised lending applications are built on relatively new and not fully battle-tested blockchain technology. There have already been several high-profile hacks of decentralised applications, so choosing which ones to use should be done carefully.
Complexity
Decentralised lending applications can be complex and difficult to understand. It's important to do your research before using any given application.
Volatility
The prices of the digital assets used to operate decentralised lending applications can be highly unstable. This means your investment can lose value quickly.
What Is an Example?
Decentralised lending is an umbrella term for any application that uses blockchain and digital asset technology to provide financial services. Some of these applications can provide anything from basic services such as savings accounts to more advanced ones such as supplying liquidity to companies or traders. One of the better-known protocols is Aave, a “non-custodial liquidity protocol” that lets anyone participate as a liquidity provider or borrower.
Aave lets you hold your digital assets there in order to earn interest income from users who then have the opportunity to borrow those assets.
Conclusion
The growth of decentralised lending protocols opens up real opportunities to earn meaningfully with the support of your digital assets. In this guide, we've covered several core strategies, each with its own advantages and trade-offs. Keep in mind that this is a fast-evolving space, and before committing to any of these strategies, you should carry out careful research. By honestly assessing your own risk tolerance, investment goals and level of expertise, you can put decentralised lending protocols to work toward a new level of financial opportunity.
