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Robin Kim graduated in economics from New York University in 2015. It borrowed more than $100,000 from the U.S. government and was quickly locked into high interest rates. She’s been trying to pay off her student loans ever since.
Eventually, Kim refinanced through a private lender to lower the interest rate, but wondered if there was any other way out. “I was paying $1,500 per month to pay off this loan,” he says. “This amount could have been better spent elsewhere.”
A former engineer and co-founder at Coinbase GalleryKim, an online platform that people can use to organize and share their NFT collections, had considered selling cryptocurrency to pay off their loans. But if he did, he would have to pay taxes on every profit he made.
Instead, Kim took out a loan through a bank. Aave loan platformIt is built on the Ethereum blockchain. He used this money to pay off his debt and is now working to pay off his new loan.
How do DeFi loans work?
Decentralized finance is an all-encompassing term for blockchain applications used to create complex financial products. Because DeFi loans are not tied to the traditional banking system, they sometimes have lower interest rates, do not affect the borrower’s credit rating, and can theoretically be held indefinitely.
DeFi loans can be based on any digital currency. This includes stable coinsare cryptocurrencies whose value is dependent on external sources such as the US dollar. To get a DeFi loan, borrowers must first deposit collateral in the form of crypto assets worth more than the amount they are willing to borrow. How much more is based on a percentage set by the lender. It’s a bit like depositing $100 in one currency and borrowing $75 in another currency.
The borrower receives the loan in fixed currencies, which can then be exchanged, for example, for US dollars. This money is used to pay off a loan, and then the borrower eventually pays off the DeFi loan to get the collateral back.
However, the benefits of DeFi come with risks. A debtor’s collateral can be liquidated if its value falls below the value of the loan. Although Bitcoin has more market liquidity than any other cryptocurrency, still quite variable, the value fluctuates an average of 3% per day. If prices drop too much, borrowers lose their collateral. (This risk is lower if the price of the collateral rises.)
Stablecoins are also target of government control, given the risks of an unregulated stablecoin market for the global economy. Regulators warned that potential fluctuations in value could result in widespread losses for stablecoin holders and destabilize the entire financial market.
A US government working group in November 2021 He suggested that Congress require stablecoin issuers to be subject to the same regulations as banks.. In February, US Representative Josh Gottheimer, Democrat from New Jersey, Stablecoin Innovation and Protection Actwill issue state-sponsored insurance for stablecoins. These steps will reduce the risk of volatility, but a government-backed coin will no longer be decentralized.
Another important risk is smart contractsAuto-negotiations that provide loans on the blockchain are not infallible. Smart contracts are executed based on predetermined conditions written into the code. This code is written by humans and mistakes, bugs or hacks can trap borrowers.
matter of trust
Therefore, borrowers should put a good amount of trust in the platform issuing their loans. More prominent platforms may take security measures to mitigate risk. For example, the platform Compound TreasuryThe community has hired security firms to evaluate the loan protocol to make sure its code is secure.
“Even so, it’s up to the end user, the developer, and the borrower or lender to truly assess the stability and risk-taking of the smart contract,” says Reid Cuming, vice president and general manager of Compound. “I think we’re still in a situation where there is a lot of room for improvement here.”
Anyone who knows your wallet address can see how much you’ve borrowed.
DeFi platforms also provide little privacy to borrowersthat is, anyone who knows your wallet address can see how much and when you borrowed.
Crypto skeptic Molly White says this divides users into three camps: people who protect their privacy at the expense of being able to use major crypto platforms, people who give up a little bit of privacy to use them, and people whose identities and crypto wallets are publicly linked. .
Many of the supposed benefits of decentralization – privacy, anonymity, and independence from companies – no longer apply, as platform choice comes down to liquidity versus privacy. And managing these risks requires technical expertise that most borrowers lack.
On the one hand, White says, some believe these platforms make financial transactions that were once the domain of experts. Open to everyone—“but, on the other hand, people get caught up in making risky decisions they don’t have the knowledge to make responsibly.”
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Who remains optimistic. He compares the situation to the early days of the internet and says that despite the risks, DeFi has the potential to go mainstream. “I think DeFi will meet par with central finance because of its transparency and openness,” he says. “The ecosystem needs to mature, but I think that’s the case with all emerging technologies.”
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