DeFi Instruments — Lending Markets

Next are lending markets. These are also a fundamental component of the entire decentralized finance (DeFi) ecosystem. What are lending markets? These are credit markets where you can either borrow money or lend money to someone else.

Let’s start with an example from the traditional financial system. If you want to take out a loan of one hundred thousand dollars from a bank, what do you need to do? You must go to the bank, sign an agreement, and leave your property as collateral. If you are unable to repay the loan, the bank can seize your property. The property acts as collateral — it could be real estate, a car, or other valuable items. Collateral must always be provided in order to receive a loan, and if the loan is not repaid, the bank takes the collateral and sells it to cover the unpaid debt.

And all of this, again, is formalized through a contract, and the borrower interacts directly with the bank — a centralized institution.

How Lending Works in DeFi

How does lending work in DeFi? Everything happens between two users — the borrower and the lender — and is enforced by smart contracts. In this case, I can borrow, for example, fifty dollars at a certain interest rate. Therefore, I must leave collateral in some cryptocurrency. This could be Ethereum or Bitcoin, and the collateral must be worth more than the amount I am borrowing. This ensures that the lender is protected and that I cannot simply disappear with the borrowed funds.

So yes, I could theoretically borrow fifty dollars and never repay it. But since I have deposited collateral worth more than the loan amount, the lender will always get their money back.

Likewise, I can act not only as a borrower but also as a lender. I can deposit my USDT stablecoins into a smart contract, and other people can borrow these funds while paying me interest. This interest accrues continuously.

And I can withdraw this money at any moment. This is the foundation on which the entire ecosystem begins. A large number of strategies use lending markets as a starting point, where you can deposit your Bitcoin as collateral and borrow stablecoins against it.

And I will immediately answer the most common question — why leave something as collateral if I can simply sell it and get dollars right away without borrowing?

Why Borrow Instead of Selling Your Assets?

This is very important. If you have a strong asset in your portfolio — for example, Bitcoin — and you do not want to sell it because you believe it will be worth more in the future, but you currently need free capital — you need stablecoins. You deposit Bitcoin as collateral, borrow, for example, one thousand dollars against it, use that one thousand dollars in various strategies, and earn profit.

Then, when you need to retrieve your Bitcoin, you return the one thousand dollars — paying an interest rate of, for example, five percent per year — and take your Bitcoin back when it is already worth more. You do not sell your Bitcoin, you keep your asset, and at the same time you receive free capital to work with other instruments. This is crucial to understand.

If you simply sold Bitcoin at a low price, later you would have to buy it back at a higher price and lose more money than if you had left it as collateral and borrowed stablecoins against it.

Example of Borrowing and Earning

Let’s consider an example where I leave twenty-five thousand dollars as collateral — that is two thousand five hundred dollars — and borrow one thousand dollars.

After this, I can use the borrowed funds anywhere. I can transfer them to another blockchain, send them to another wallet, and freely do anything I want — deposit them into stablecoin staking or earn yield in other instruments. After I finish working with the borrowed funds and receive some profit, I can repay the loan. For example, if over six months I turned one thousand dollars into one thousand three hundred dollars.

I repay one thousand fifty dollars, including interest, and the remaining two hundred fifty dollars is my profit. At the same time, my Bitcoin remains unchanged. This means I can withdraw my full collateral of twenty-five thousand dollars, plus the two hundred fifty dollars I earned while using the borrowed funds elsewhere. This is how the entire lending-market system works.

This is the simplest and most basic strategy for generating passive income on strong assets, such as Bitcoin or Ethereum.

What Happens When the Price Falls?

But what happens if I deposit zero point twenty-five Bitcoin as collateral — worth two thousand five hundred dollars at the current price — take a one-thousand-dollar loan, and then the price of Bitcoin starts falling?

The price of Bitcoin approaches the value of my loan. A little more — and the collateral will be worth less than the loan. In theory, this would allow me to run away with the money and never return it.

What happens in this case? The system triggers liquidation, which allows other participants to buy your collateral at a discount and repay your loan. Because there are liquidators who purchase collateral close to liquidation, all loans always remain one hundred percent secured.

Even if someone borrows one thousand dollars, disappears, and never repays the loan, their collateral is simply liquidated and paid to the participant who provided funds to cover the debt.

In this case, if the price of Bitcoin falls below a certain threshold (each asset has its own threshold and its own percentage), I simply lose my Bitcoin, but I still keep the one-thousand-dollar loan. I no longer have to repay it, because my Bitcoin has already been liquidated and my debt has been paid off for me.

Therefore, I can keep the one thousand dollars. This is, again, the worst-case scenario of what can happen. That is why it is better not to allow liquidation and to carefully monitor the price of the asset that is used as collateral for your position.

Summary

To summarize: the foundation of decentralized finance consists of stablecoins, lending markets, decentralized exchanges, and oracles, which I will explain later. This is the fundamental base on which the entire decentralized finance ecosystem is built, as well as all strategies for creating passive income and growing capital in an investment portfolio.

This is the foundation, and on top of these lending markets and decentralized exchanges there are many additional instruments that can be combined to create strong passive-income strategies and earn within the decentralized finance ecosystem.

These materials are created for educational purposes only and do not constitute financial advice.