What are Lending Pools?
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As mentioned in our section on Decentralized Lending and Borrowing pools, removing the middleman with DeFi rebuilds traditional financial systems more efficiently through automated smart contracts.
DeFi Lending and Borrowing platforms like Maker and Compound have seen significant traction in recent times making High Interest Savings DeFi's First Killer Application.
✅ Higher Interest Rates compared to traditional financial markets savings accounts.
✅ Instant Liquidity allows loans to be made for as short as 10 to 20 seconds as compared to traditional lending platforms that might require lockup periods of up to a few years.
✅ Interests paid out every 10 to 20 seconds as interest rates are calculated algorithmically according to supply and demand as opposed to monthly payments from banks. This enables automatic compounding of interest payouts.
✅ Pooled Loans means that a lender does not need to find a borrower as the smart contract replaces the matching role of the financial intermediary in traditional markets. This allows for maximum efficiency and makes for a highly scalable financial application.
The easiest way to visualize Lending Pools is as a automated pawnshop pool.
Pawnshops typically offers collateral-based loans — which means that a loan is secured by your assets. You take in assets of value that you own, and the pawnshop will offer you a loan against these assets. The pawnbroker then keeps your item until you repay the loan. Loan amounts are usually a fraction of the item’s actual value.
Similarly with lending pools, borrowers get a loan and offer digital assets as collateral into the automated smart contract pool.
These loans are always over-collateralized to hedge against volatility risks. This ensures that collateral can be seized and liquidated to cover the loan in the event that prices of these digital asset collateral drop below their loan amounts.
Lenders send their funds directly into a smart contract and receive interest from borrowers in the lending pool.
Borrowers borrow directly from the Lending Pool smart contract by providing digital asset collateral to the smart contract as described above and pay interests on these loans.
These digital asset owners are typically borrowers who have digital assets but do not which to sell them, yet require immediate liquidity for other uses and are willing to pay these higher interest rates.
The main reason spreads exist between Lending and Borrowing rates in a Lending Pool is due to the fact that not all the funds from Lenders are being lent out but everyone who is Lending will receive a proportional share of the Borrowing interest generated.
For example, if borrowers are currently paying 10% interest and utilization is at 50% , lenders will only receive 5% interest as the 10% interest has to be spread over the whole pool of money even though only 50% is being used.
This gives instant liquidity to both Lenders and Borrowers and is indicated by the Utilization Ratio of the Lending Pool.
There is also a small fee on interest earned that goes into an insurance pool for different Lending Pool protocols.
