Lending Protocols - Loans Aren't Necessarly A Bad Thing

Disclaimer: Your funds are your responsibility. All information in this article is reflecting my own investing strategy and should not be taken as financial advice.

Farming with your own money is probably the best way to get into DeFi but once you gain some experience, you should introduce yourself to lending as well. Unlike your local bank, lending protocols won't ask for paperwork, ID, country of origin, and all that stuff. Protocols only recognize collateral and if you have some you are eligible for a loan.

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How do they work?

You can look at lending protocols as the future of banking. There is no central point of control and anyone can borrow or save money. Here is a very simple example.

Best case scenario

You have 1 ETH and it is currently worth $3k. You would love to hold on to that ETH because you see a lot of upside potential in the near future, but you need cash immediately. The obvious thing to do would be to sell some of your ETH but lending completely changes this.

Instead of selling, you can put your ETH in a lending protocol like AAVE or Cream and take out a loan in USDT, USDC, or any other stablecoin of your choice. Usually, 75% of your collateral can be borrowed but if you want to stay safe, always keep it at 50% max.

Let's say you need $1.5k and you take that out as a loan while keeping 1 ETH in the protocol. The price of ETH goes up by 100% and now you have $6k collateral. You withdraw 0.25 ETH from the protocol, market sell it for the stablecoins you borrowed, repay your loan and take out 0.75 ETH.

If you didn't take out a loan you would have 0.5 ETH because you would be forced to sell 0.5 ETH to begin with.

Worst case scenario

You deposit 1 ETH in the lending protocol, take out a loan of $1.5k and in the next few weeks ETH drops down by 50+%. In this case, your debt will be larger than your collateral so someone will need to repay your debt and take your ETH in exchange. This is called a liquidation process and usually benefits those that chose to repay your debt since they get to "buy" ETH at lower prices.

Liquidators can get a premium of 8-20% depending on the protocol and you will be paying for that premium with your own collateral. Keep in mind that this is all run by smart contracts so no one will come knocking on your door and asking if they can liquidate you. If you meet liquidation requirements and repaying your debt seems profitable to someone, your position will be liquidated as soon as possible.

How To Utilize Lending As a Farmer?

I will presume that we all have stacks of crypto that we are holding for the long term. Usually, this is BTC, ETH, LTC, or some other OG crypto. So if you are keen on farming but have no spare funds consider taking out a loan with your crypto collateral.

It is a well-known fact that the richest people in the world operate on debt and never sell collateral for investments. Why would we do things differently?

Instead of selling your crypto to invest in a new project, take out a loan that doesn't exceed more than 25% of your total collateral. Put that money to work and once you have made a profit, repay your debt and keep all of your long-term holdings.

Work smart, not hard.

Using Lending Protocols As Leverage

Let's say you have a gut feeling the markets will explode in the next few weeks or months but have no more money to put into it. Your options are leverage trading or leverage lending. I like the latter a bit more.

Example:

Put 1 ETH in AAVE, take out a loan of $1.5k, and buy 0.5 ETH in the market. Deposit that ETH back into the protocol, take out another loan, and repeat the process. Eventually, you will be able to almost triple your collateral but this is a VERY risky strategy. Your borrow limit will be dangerously close to your liquidation levels so keeping a close eye on the situations is a must. On the bright side, you will be exposed to ~3 ETH instead of 1 and if your predictions were right, your will net 3x the profits.

When dumbed down completely, this is just leverage trading but with no centralized exchange involved. You are the only one deciding the limits and boundaries. If you are interested in shorting the market, just reverse the process:

Deposit stablecoins as collateral, borrow the currency you want to short, market sell, and deposit the satablecoins from the sale back to the protocol. Rinse and repeat until you are happy with your position. If you were right and the markets do tank, your debt will decrease and you will owe less in dollar terms.

Bottom Line

If you are new to lending be sure to start with tiny deposits and loans. The best way to do this is to use AAVE on Polygon since the fees are super-low. Test it out, see if it makes sense for you personally, and slowly build your positions. Always keep in mind that every mistake you make will cost you money so be sure to start small.

If utilized correctly, lending can be a very powerful tool that significantly increase your returns. Play your cards right and you will be rewarded.

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