Lending and Borrowing Terms

Before moving on with the article, We will go through a few basic terms used in finance:

Liquidation - The act of turning assets into cash is called liquidation. The assets held by an entity in the form of cash are called liquid assets. The ability of an asset to be converted into cash is generally referred to as Liquidability.

Credit/FICO score: A credit score from 300 to 850 depicts a consumer’s credibility. It is based on credit history, timely loan repayments, etc. The higher the credit score, The more likely you are to get a better loan offer.

Collateral: Asset against which something is borrowed.

Interest rate - The part of the loan that is charged as interest to the borrower. The rate of premium paid over the actual amount borrowed.

Return of investment - The portion of the investment provided as an incentive for providing liquidity or letting your assets be borrowed is called the rate of returns.

Over-collateralization - When the value of the collateral provided supersedes the value of assets borrowed, It is called over-collateralization.

Financial solvency - The Ability of an entity to meet its long-term debts and other financial obligations.

Borrowing capacity - The maximum amount an entity can borrow without compromising its financial solvency.

APY - APY stands for Annual Percentage Yield. It is the total amount of money, i.e., the return of investment earned by a bank account in a year.

APR - APR stands for Annual Percentage Rate. It refers to the interest generated by the sum lent or borrowed in a year.

Inflation - It is the rate of rise in prices of goods and services.

Mortgage - It is collateral produced in the loans taken for housing, Where the collateral is the real estate itself. It is basically an agreement between the lender and borrower that allows the lender to take ownership of the property in case of default in repayment by the borrower.

Loan-to-value (LTV) ratio - Often used in mortgage assessment. It is an assessment of lending risk that lenders examine before approving a mortgage. Often used in mortgage lending in order to determine the amount to be put in a down payment and whether a lender will extend credit to a borrower. It is to be noted that lower LTVs are more favorable to the lenders. 

LTV = (Mortgage amount / Appraised property value)

Lending And Borrowing Basics

What do the terms lending and borrowing mean?   

Lending

By definition, Lending is the act of allowing someone else or another entity to make use of the assets available but not currently useful to the lender.

In financial terms, Lending is the act of letting an institution make use of its assets in return for some compensation, usually in the form of interest. 

An example can illustrate the purpose of lending.

Say you have $2000 worth of assets not of immediate use. You might want to put it in a locker to keep it safe. But this locker's only functionality is to keep the money safe; thus, the money just sits there idly while slowly reducing in value due to inflation. Instead, One could make it available to a financial institution or protocol for them to use and reap the benefits of return on investment. This way, the assets are safe and not diminishing in value, given that the APR compensates for inflation.

One can see that the key object of lending is to get a fixed return on your investment, as opposed to the stock market, where there is a risk of loss. The financial institutions offer a fixed interest rate on your investment, Though the prospect of profits is small. It is much more stable than the stock market in terms of returns.

Borrowing

By definition, Borrowing is the act of receiving something from someone under the agreement that the asset or an agreed-upon equivalent of the asset borrowed will be returned after a certain period. 

In financial terms, Borrowing is when you get assets you do not have and wish to have against assets you already have (Collateral). The borrower is lent assets on the agreement that they shall repay the asset in installments (or) premiums within a given period. 

The purpose of borrowing is simply to use an asset you do not currently have by producing something you already own as a security of repayment of the borrowed asset.

Notice how this can also be practiced as a form of swapping assets. 

The disadvantage is that the interest rates on borrowing can be high and default in loan repayment means you are worse off in terms of future loan requests.

Advantages of Lending and Borrowing

• Lending and borrowing facilitate the flow of resources from the people with surplus resources who do not have a use for them and people without a particular resource in necessary amounts. This trading, of time value of assets benefits both the parties.
• Lending prevents the devaluation of money held by a person by generating value via interests.
• Lending ensures the circulation of resources held in surplus which otherwise would be locked up with one person/ entity and unusable.
• Lending and borrowing play a crucial role in the ecosystem of small businesses. Providing them with resources they otherwise would not have to sustain their business initially

Lending and Borrowing in Traditional Finance

What is it?

The traditional system of finance is one where there is a hierarchical structure. This hierarchy decides the crucial decisions to be taken, including but not limited to rates of return on investment, rate of interest on loans, different plans, etc. 

Its Principle

Traditionally, lenders deposit their money in banks. The bank then uses this money and provides loans to borrowers for some rate of interest. The lenders get compensated with some return on their investment, But the interest rate for the borrower is higher than that of the rate of returns offered to the lender—this difference in the rates in the profit made by banks. 

An outline of the process

Banks are built on a system of trust. They loan money only to those who they deem will be credible enough to repay the loan. This is calculated by taking into account past loan repayments, timely installments, etc. By doing this, they create an index that tells them how likely it is that the customer will repay the loan.

After the initial verification of your eligibility, and various paperwork related to the legal agreements that the bank has to impose on the lender, borrower, and itself. You can borrow money from the bank. It's important to remember that there is a limit on how much you can borrow, with interest rates depending on the collateral produced, type of loan, etc.

In loan agreements, there are a few key things that are always specified. These include the repayment period, what legal actions can be taken against the borrower in case of default, the interest rate, and any fees that may be applicable. Once the loan is sanctioned, the borrower must pay it back in monthly instalments. The repayment period for most loans ranges from one to seven years.

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Fees

On top of the premiums paid, The bank often levies other charges on the borrower like,

1. Application fee: For the process of applying for a loan.
2. Processing fee: For the processing/ sanctioning of a loan.
3. Origination fee: The cost of securing a loan.The 
4. Annual fee: A yearly fee that must be paid to the lender.
5. Late fee: The fee paid on late pay
6. Prepayment fee: The cost of paying a loan off early.

Regulations

Multiple regulatory bodies keep the functioning of banks in check. This is necessary because banks, being hierarchical organizations aimed at making profits, can quickly push their margins by increasing the borrowers' interest rates and reducing the rate of returns for lenders. Since banks lack transparency to the general public, The regulatory bodies play a crucial role in the ecosystem of traditional finance.

Some regulatory bodies include Office of the Comptroller of Currency(OCC), FDIC(Federal Deposit Insurance Corporation), FRS (Federal Reserve System), etc., Which form guidelines on interest rates, loan repayment, etc.

Advantages

• Heavily regulated - Though there is a possibility of scams, There are regulatory bodies whose job is to protect the consumer and stakeholders from such scams.
• Accountability - The lender, the borrower, the bank, and all transactions are registered and monitored. The possibility of your assets getting locked without return is next to impossible. Can assets get locked? We will look into that later when we talk about crypto finance.
• Accessibility - Though the banks have a lot of gatekeeping mechanisms in place that restrict the actions of borrowers, It is still very accessible. Banks have a well-developed supply chain, making it accessible to even those who are not "tech-savvy."
• Well-developed schemes - The banks have developed loans for multiple needs like personal, housing, vehicle, and educational loans. Each with its perks. This, again, coupled with integration into web2, Makes it more accessible and user-friendly.
• Uncollatorized/ Unsecured loan - An Uncollatorized (or) Unsecured loan is one where the bank does not demand any type of collateral from the borrower as security for repayment of the loan, Hence the term unsecured loans. They instead depend on the creditworthiness of the borrower to approve the loan. Examples include personal loans, credit cards, and student loans. 

Disadvantages 

• Hierarchical - The structure of a hierarchy here can be seen as a disadvantage because the majority of the stakeholders, Do not have a say in the decision-making.
  In the short term, the interest rate is set by central banks that regulate interest rates.
• ‍Inefficient - Banks spend large sums of money to setup fancy buildings and offices, And the workforce in banks, Consisting primarily of people, Is prone to inefficiency and burnout.  Not to forget the process of loans is an extensively time-consuming process with a lot of paperwork.‍
• Transparency and Returns - The banks do not disclose their profits and margins to the general public. Banks often offer paltry returns to the lender in comparison to other investment opportunities.
  Note that the lesser the returns offered to the lender, More the profit margin for the banks, One can see how this can be problematic. ‍
• Credit score - You must maintain a good credit score to qualify for good-quality loan plans. But this would mean it is harder to get loans as you default more.‍
• Movement of assets - The movement of assets from one system into another is lengthy and time-consuming. It is sometimes impossible to move assets within the systems and protocols that the same bank offers.‍
• Fees - Apart from the premium being paid, other fees are often clipped onto the borrower. As already explained, these are processing, origination, annual, late, and prepayment fees.‍
• Lack of innovation - The banking sector has been acting on more-or-less the same principles and workings without too many changes in the last 10 or so years.

Lending and Borrowing in Crypto/DeFi

The financial organizations and protocols in the blockchain that work on a decentralized version of traditional finance are called DeFi organizations. 

What is it?

Decentralized finance is one where there does not exist a hierarchical structure of power. It does not have a middleman. Instead, it works on peer-to-peer technology. In DeFi lending and borrowing, There are no "people" working for you to apply for loans, sanction your loans, check your credit score, etc. It is all done by blocks of code called smart contracts. Begs the question, What principle do they work on? What is their exact function?

Its principle

It is the same as the traditional lending and borrowing system: the borrower puts up collateral to be able to borrow, and the lender gets compensated for sharing his resources. DeFi lending platforms are built to function without trust or a credit system. Instead of using credit, DeFi lending is based on a system of over-collateralization and liquidation to facilitate It transactions between unclear and unknown lenders and borrowers. But how is this achieved? What is overcollateralization? How does the system work without anybody to oversee who borrows and who lends?

How does it work?

Without a facilitating body, How does the protocol know whose assets to lend to whom? This is done by something called a liquidity pool.

The protocol maintains a "liquidity pool" where all lenders' assets (liquidity) get pooled. The protocol then takes assets from this pool to lend to the borrowers per their needs. Because of its inherent structure, It is impossible to know whose assets are being borrowed by whom in DeFi lending and borrowing. The process goes like this;

The borrowers ask for a loan by "over collateralizing" the assets they own in return for the assets they want. That is, You have to produce collateral that is more than the value of the asset you wish to borrow. Suppose I want to borrow $100 worth of Ethereum. Then I would be required to give $120 worth of some other asset as collateral. This way, The lender gets the value of the assets he lent back in case of default in loan repayment by the borrower and to value of collateral from falling below the value of the loan taken. The borrower has to repay his loan with interest to the DeFi lending platform. 

The lenders are compensated for their resources by providing them with crypto assets, primarily the DeFi protocol's crypto coins.

These crypto coins can be exchanged for other cryptocurrencies or buy crypto assets in the same ecosystem. They are also given crypto tokens which give lenders a say in the changes made to the protocol. Since DeFi is decentralized, The changes made in the protocol are often decided by the majority and minority votes. These tokens act as the equivalent of a vote. A person can vote many times in this scenario as long as he has the tokens to count as a vote. 

Over-collateralization

As previously mentioned, over-collateralization is the act of producing collateral value exceeding the value of loan taken. Why would this be done? What could be its use cases in financing?

Traditionally, over-collaterization is used as a credit enhancement technique, That is it is used as a means of risk-reduction to the lender in case of financial stress. By overcollaterization, credit risk is eliminated; The lender could liquidate the collateral to recover any possible loan losses.

This also works in the borrowers favor. With the increased security provided to the lender, The borrower is put in a position where they can negotiate for a better interest offer on the loan.

For example, Suppose a business owner wishes to borrow a sum of $30,000. The borrower is able to find a lender who is willing to lend him that amount at the interest rate of 12% per annum. But this is an unfavorable rate for the borrower and he wishes to get a lower interest rate on the loan. Having assets worth $45,000 in the form of real estate, He offers the lender the assets as collateral (Overcollateralization). The lender, Now being provided with credit security, Agrees to the borrower’s proposal of an interest rate of 9% per annum. 

Overcollaterization comes to the rescue when dealing with highly volatile assets like cryptocurrencies. In case the value of the collateral dips beyond the actual value of the loan taken, Then the lender’s assets are compromised. To prevent this, DeFi organizations set the percentage of overcollateralization. In case the value of the collateral dips beyond a certain point, It is liquidated and the position of the lender is secured.

An overcollateralized stablecoin has a large number of cryptocurrency tokens maintained at a reserve for issuing a lower number of stablecoins. This offers a buffer against price fluctuations.

DAO has a loan and repayment process utilizing a collateralized debt position via MakerDAO to secure assets as collateral on-chain.

Another case where overcollateralized loans are used is leveraging interest rates of currency taken loan against and invested in. Let me explain, Say you have a currency x which does not yield much returns on its own, You can use currency x to overcollateralize and take a loan of currency y, which is a highly valuable liquidity currency in another market and thus provides a high rate of returns. Now, The user can take a loan of currency y, invest it in another market and make a profit off of the difference in the rates of interest of the loan and that of the investment made in currency y, While still holding currency x in his power which would not be possible in the case of swapping.

Overcollateralization is a common practice in securitized financial products like Collateralized loan obligations (CLO) and Mortgage Backed Securities (MBO). 

Fees

There are often no fees clipped onto the borrower. The borrower is simply to pay back the loan with interest.

Regulations

Since DeFi is not reinventing the wheel in terms of its basic financial workings, Many of the regulations imposed on the regular banking sector also apply to DeFi organizations.

The reality is though regulations exist, Many organizations do not adopt them. And unlike traditional banking, There is a significant risk of your assets being locked into a smart contract, protocol malfunctions, price fluctuations, etc., that are not well regulated. 

Advantages

• Speed -DeFi lending platforms are made possible by blockchain technology and the rules for lending and borrowing are encoded into the Smart Contract. This helps to expedite the process as there is no human interaction required and the actions are performed instantaneously. The majority of services provided by DeFi platforms are available 24x7. Taken together, these factors make DeFi a quicker and more effective way to lend and borrow money.‍
• Flexibility - Assets can be moved anywhere anytime without permission from a governing body and without having to pay unforeseen fees on such transfers.‍
• Open - No lengthy processes, assessments, and paperwork go into applying for a loan. All you need is a crypto wallet.‍
• Immutability - Blockchain’s decentralized architecture ensures that the data it contains cannot be tampered with. This increases security.‍
• Programmable - The users can change any feature of the protocol by voting a change on it. This ensures that the users are less likely to be wronged by a hierarchy's gains.

Disadvantages:

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• Taxes - The user has to maintain their record for tax purposes, And it varies from region to region, causing much confusion. Adding to that, Profits made from any kind of crypto transaction are heavily taxed in many countries, which demotivates users.‍
• Volatility - The Crypto market is highly volatile. There is a possibility of the value of assets dipping enough to cause a loss for the lender or the borrower. ‍
• Tech failures and hacks - Being a new technology, The possibility of it coming under a hack attack is relatively high. The industry is evolving with each hack attack, but the case of a new glitch emerging is always high in new technologies. Tech failures causing a substantial quantity of assets to be locked up in a smart contract without a way out are not unheard of.‍
• Pseudo Anonymity - Not knowing who is behind the given address is a double-edged sword because it could be an organization of people trying to drive the prices of assets in a blockchain in their favor.

Traditional vs Decentralized finance

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• Structure - Traditional financial institutions are built on hierarchical foundations; They work to satisfy the interests of the apex of the hierarchy. DeFi's structure is decentralized, and there is no ultimate governing body. Its users run it.‍
• Working -  In traditional finance, The bank or some other financial institution acts as an intermediary between the lender and the buyer. It makes profits off of the difference in rates of interest it specifies. DeFi has no intermediary, and the transaction follows a peer-to-peer structure.‍
• Application process - Banks have an extensive process of checking the borrower's eligibility. They have lengthy Application and Sanctioning; They also levy fees on these processes.
  In DeFi, however, it is seamless, and often the borrower only needs to have a crypto wallet to get a loan.‍
• Collateralization - In Traditional finance, we do not over-collateralize. We use an asset as collateral to get assets against it. However, In DeFi, the idea of over-collateralization is adopted.‍
• Differences in APY - The rate of returns in traditional finance is paltry. There have been cases of more than a hundred percent rate of returns in DeFi. Though this symbolizes volatility and instability of the market, On average DeFi lending offers much more return on investment than traditional lending.

Conclusion

Blockchain is an exciting innovation that quickly finds applications in various realms of human endeavor. The inculcation of blockchain in a field like finance, Promotes transparency, flexibility, and accessibility, where these qualities are scarce. 

With blockchain being a future technology, It is of substantial worth for one to know its applications in the field of finance.

Both traditional and Defi have their advantages and disadvantages. This article aims to educate the reader on the basic workings and principles of the current financial systems, not as a guide to investing. One must carefully weigh these facts before interacting with either of these systems. 

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