Understanding Lending Pools and Their Role in DeFi Loans

In the ever-evolving landscape of finance, DeFi has emerged as a new opportunity, offering an innovative approach to borrowing and lending. But why consider DeFi loans in the first place?

At the core of this DeFi lending revolution are lending pools, which play a key role in facilitating DeFi loans. This chapter explores the fundamental concepts behind lending pools, their various forms, and the key elements that define them.

The articles in this series are extracts from the E-book: Lending Pools Unpacked, now available for download.

What is a lending pool?

In short, lending pools facilitate DeFi loans and are a central component that underpins the DeFi lending ecosystem. They are dynamic pools of funds provided by certain communities or parties, enabling borrowers to access loans and lenders to earn interest. But why do these lending pools even exist?

In traditional finance, banks act as intermediaries, connecting lenders who deposit their money to borrowers who need loans. DeFi lending, powered by lending pools, on the other hand, streamlines this process through the use of blockchain and smart contracts. Borrowers can secure loans quickly, often without extensive credit checks, while lenders earn interest on their assets. This transformation reduces reliance on centralised institutions, promoting financial inclusion and global collaboration among lenders and borrowers. Picture it as a modernised version of familiar community-based lending systems, but with the advantages of blockchain's security, transparency, and efficiency. It is like a digital cooperative where people help each other financially, only now it's on a global scale and operates 24/7, seamlessly connecting lenders and borrowers worldwide.

Similar to existing lending solutions, several key parties play distinct roles in lending pools:

Borrowers

Borrowers are individuals or entities seeking to obtain loans through DeFi lending pools. They provide collateral to secure their loans, and their role is to adhere to the terms and conditions of the loan agreement. This is similar to how borrowers interact with traditional lending institutions.

Lenders

Lenders, often also referred to as liquidity providers, are participants who provide liquidity to the lending pool by depositing their assets, which are then lent out to borrowers. These assets tend to be stablecoins. Lenders earn interest on their deposited assets as compensation for taking on the risk associated with lending. This process is much like depositing funds into a savings account at a bank.

Lending pool

An automated smart contract that governs the operations of the pool. It manages the allocation of funds, interest rates, collateralisation ratios, and the distribution of interest payments. This automated management differs from traditional banks, where human intermediaries oversee lending operations.

DeFi protocol

The overarching framework that hosts the lending pool. It sets the rules, enforces smart contracts, and ensures the integrity of the lending process. This can be compared to how the traditional financial system provides the underlying infrastructure on which banks operate.

Key aspects of lending pools

In the world of DeFi lending pools, several critical aspects shape the dynamics of borrowing and lending. Understanding these key elements is essential for participants looking to navigate this evolving landscape effectively:

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Annual Percentage Yield (APY)‍

This metric measures the annualised rate of return on investment, accounting for compounding interest. In DeFi lending pools, it signifies the potential earnings or losses for liquidity providers.  However, it also underscores the exposure to market fluctuations, potentially leading to losses if asset values decline significantly.

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Utilisation rate 

The utilisation rate paints a vivid picture of how efficiently a lending pool deploys its capital. It measures the proportion of the pool's funds currently in use as loans. A high utilisation rate suggests a strong demand for loans, potentially leading to competitive interest rates for lenders. In contrast, a low utilisation rate may indicate underutilised capital, which could impact the overall profitability of liquidity providers. Different types of lending pools may have varying utilisation rates based on their specific characteristics and user behaviours.

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Seniority 

When you lend money to lending pools, these pools can have different levels of seniority, similar to the traditional world in which you have junior and senior bonds. 

In DeFi, it means that lending pools with different levels of seniority use a multi-token structure. In other words, it means you can receive two types of tokens when lending money to the pool, namely junior and senior tokens. These tokens represent different positions within the lending pool, and their characteristics can vary depending on the specific pool type. Some lending pools may even have additional levels of tokens.

Senior tokens prioritise safety and stability. They enjoy priority when it comes to receiving interest payments and capital repayment. Although there is still a risk of losing your capital in extreme cases, holding senior tokens means you have a more conservative and secure position within the lending pool. In case of defaults, senior tokens have priority, reducing the risk of losing your capital.

In contrast, junior tokens offer the potential for higher returns but come with more risk. They are exposed to greater risk, including the possibility of losses if the lending pool encounters defaults or liquidations. Junior tokens are for those willing to take on more risk in pursuit of potentially higher rewards.

Another important point to mention is that some lending pool platforms use a different structure. Instead of having multiple tokens within one pool, lending pool platforms may operate entirely different pools at various levels of risk.

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Collateral

The choice of collateral within lending pools is a key determinant of risk and reward for both borrowers and lenders. Collateral can differ significantly between lending pools in terms of type and value. The type of collateral accepted within a pool may range from cryptocurrency assets to real-world assets and can impact the pool's risk profile. 

A higher collateralisation ratio, also commonly referred to as the loan-to-value (LTV) ratio, typically indicates a lower risk for lenders but may limit borrowing capacity. Conversely, pools with lower collateralisation ratios may offer borrowers more flexibility but pose greater risks to lenders in the event of defaults.

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Liquidation threshold

 The liquidation threshold represents a critical safeguard within lending pools. It signifies the point at which a borrower's collateral may be liquidated to protect lenders and the overall stability of the pool. The specific threshold can vary, impacting the risk profile of the lending pool. 

A lower threshold may trigger liquidations more readily, potentially protecting lenders from significant losses but requiring borrowers to maintain a higher level of collateralisation. In contrast, a higher threshold may provide borrowers with more freedom but could expose lenders to increased risk in the event of collateral value fluctuations.