How DeFi lending protocols work: A developer’s guide

Идея с картой стала логичным продолжением нашего опыта в онбординге. Поначалу мы попробовали организовать теоретическую подготовку новичков с помощью книги «How to DEFI» от Coingecko и пары статей по ключевым вопросам web3 сферы. Книга, безусловно, отличная и авторы большие молодцы, но, к сожалению, этого оказалось критически мало.

После пары онбордингов, стало очевидно, что такой подход не позволяет дать полноценное представление о мире децентрализованных продуктов: нужна была система. Такой способ организации тем, источников информации по ним и вопросов, которые бы полностью закрывали потребности специалистов разбираться в web3 инструментах, продуктах, технологиях с их возможностями и ограничениями. И поскольку web3 – это очень быстро развивающаяся и постоянно меняющаяся сфера, эта система знаний должна регулярно обновляться и пополняться новыми источниками информации и вопросами для самопроверки.

It would be best to define what DeFi lending protocols are before continuing with the details. DeFi lending protocols are decentralized platforms that make it possible to lend and borrow digital assets without needing traditional financial intermediaries like banks or credit unions. To ensure the transparency and reliability of the process, DeFi lending protocols are powered by blockchain technology.

Definition and Key Features

DeFi lending protocols use blockchain networks. Thanks to that, users can engage in peer-to-peer (P2P) lending pools. The process is simple. A borrower provides collateral in the form of a digital asset, and lenders deposit their liquidity pools to earn interest. Smart contracts automate the entire process. The process includes Interest calculations, collateral management and loan liquidation.

Key features include:

• Decentralization. Decentralization means there is no central authority to control the lending process. The code and community manage the process.
  Transparency. Contract terms and transactions are completely visible to all parties.
• Accessibility. As long as you have a digital wallet and internet connection, you can participate in the process.
• Automation. Operations are completely smooth and there is no need for any manual intervention.

Comparison with Traditional Lending

To better understand how De-Fi lending protocols work, you can check the tablet below.

Use Case$s of DeFi Lending Protocols

1. Personal Loans. It is easy to access funds quickly by collateralizing the crypto holdings.
2. Yield Generation. DeFi lending protocols are also ways of earning passive income by depositing assets into lending pools.
3. Margin Trading. To increase the leverage, traders borrow assets.
4. Business Financing. Especially newly found startups use Defi Loans to fund their operations in the early days without needing bank loans.

​So far, we explained the basic principles of De-Fi lending protocols, and the differences between DeFi and traditional intermediaries. Now, we can continue our guide with advanced information about lending protocols. In this section, we will explain how DeFi lending protocols operate, its components, and a step-by-step guide for the best user experience.

Core Components of DeFi Lending Protocols

The best way to understand how DeFi lending protocols work is to break down their key components.

• Smart Contracts. The main element of the process. These contracts are self-executing coded contracts. Smart contracts manage the transaction process, calculate interest,and ensure collateral management.
• Lending Pools. Lending pools are components that facilitate DeFi loans. They create liquidity that borrowers can access.
• Collateralized Loans. Collateralized loans mean that borrowers have to deposit assets with more than the amount they loan to minimize the risk.
• Tokens and Digital Assets. Tokens and digital assets also play a crucial role since borrowing and lending mostly involve cryptocurrencies or stablecoins.

1. Lender Deposits Funds:

a. The first step of the process is a user —also known as the user- deposits digital assets into the protocol’s lending pool. Cryptocurrencies like Ethereum and stable coins are popular digital assets.
b. Then, these funds become part of the liquidity pool. After this moment, borrowers are able to loan it.
c. After that, lenders can earn interest based on the standards of the pool.

2. Borrower Requests a Loan:

a. The second step in the process is the loan request.
b. Borrowers can submit a loan request by locking up collateral in the protocol. For example, borrowers can deposit $150 ETH to borrow $100 in stable coins.
c. The platform decides on the loan-to-value (LTV) ratio. This ratio defines the amount of money the borrower can borrow against the collateral.

3. Smart Contracts Execute the Transaction:

a. This is where smart contracts play their role. They automate the loan and ensure the borrower receives the desired amount.
b. Interest rates are dynamic and supply and demand in the pool defines the interest rates.

4. Loan Repayment:

a. The loan is repaid with accrued interest. The smart contract releases the collateral after the repayment is done.

Liquidation (if necessary):

a. The protocol can liquidate the collateral to protect the lender when the value of the collateral falls below a specific amount.

Comparison: Collateralized vs. Non-Collateralized Loans

To better understand the differences between collateralized and uncollateralized loans, you can check the table below.

​We can talk about 4 key features of DeFi lending protocols.

1. Permissionless Access. Contrary to traditional credit requirements, anyone can lend or borrow assets.
2. Transparency. Users can verify the data independently since all transactions are kept in the public blockchain.
3. Efficiency. Especially compared to traditional loans, smart contracts let users have faster executions.
4. Dynamic Interest Rates. Based on the supply-demand ratio, interest rates are dynamic.

Example Workflow

Lending Example:

Let’s say a user deposits 1 ETH into a lending pool. The protocol issues interest-bearing tokens (e.g., ETH), representing the deposit plus accrued interest.

Borrowing Example:

A user locks up $200 worth of stablecoin to borrow 0.5 ETH. When the borrower’s collateral value falls below a specified ratio, a liquidation event takes place.

Technical Architecture for DeFi Lending Protocols

As you can guess, the technical architecture of DeFi lending protocols is the blockchain technology. The most important players of this architecture are smart contracts, decentralized token systems and security measures. After reading this section, you’ll be able to understand how these components play their role in the process.

​Smart contracts are basically codes on the blockchain field. In DeFi lending protocols, they are key elements. They are completely responsible for transfers, interest rates, and collateral management.

Key Roles of Smart Contracts:

1. Loan Issuance and Repayment. Smart contracts Automatically issue loans to borrowers. They also track repayments.
2. Interest Calculation. Based on the demand/supply ration on the market, smart contacts adjust interest rates.
3. Collateral Management. If/When collateral-to-loan ratio falls below a specific ratio, smart contracts trigger liquidation.
4. Security Measures. To prevent unauthorized access, they include security mechanisms.

Challenges and Solutions:

• Vulnerability to Exploits. To find out bugs and vulnerabilities, regular contract audits play a crucial role.
• Gas Fees. To reduce the transaction costs on networks, optimized codes are the best way.

User Interface and Experience

To provide users with a smooth UI (user interface) is also an important aspect of DeFi lending protocols.

Core Aspects of UI/UX:

1. Simple Onboarding. This is the first step of a good UI. Users should be able to connect wallets seamlessly.
2. Dashboard. Dashboards should provide users with real-time data.
3. Automation. There must be tools to guide users through the whole process such as withdrawal, loan or deposit.

Blockchain Integration

For a secure and transparent operation, DeFi lending protocols work on blockchain networks. Thanks to blockchain networks, protocols can work cheaper and faster.

Popular Blockchain Options

The most popular blockchain options for the DeFi lending protocols are below.

1. Ethereum. Although the gas fees are high, Etherum is still the most popular blockchain in DeFi lending protocols.
2. Binance Smart Chain (BSC). Binance Smart Chain is also a popular blockchain option in De-Fi lending protocols. Lower fees and faster transactions are important factors for its popularity.
3. Solana. Solana is popular due to its low costs and throughput.

Key Considerations:

• Scalability. The network you choose should support high transaction volumes.
• Interoperability. Thanks to cross-chain solutions, you’ll be able to enable asset transfers between blockchains.

Tokenomics and Liquidity

Tokens are also central elements of DeFi lending protocols, they power everything from governance to liquidity incentives.

Types of Tokens

There are three types of tokens used in the DeFi lending protocol process.

1. Utility Tokens. These are the tokens used within the platform for rewards and payments.
2. Collateral Tokens. These tokens are digital assets that borrowers deposit as collateral.
3. Interest-bearing Tokens. These are the tokens issued to lenders that accrue value in time.

Impact of Tokenomics

• Liquidity Mining. Liquidity mining incentivizes users to provide liquidity by rewarding them with governance tokens.
• Protocol Governance. Token holders are able to vote on protocol updates and free structures thanks to protocol governance.

Security Best Practices

DeFi protocols must be secure. Secure protocols are ones that are able to find out vulnerabilities, and solve & prevent them.

Security Strategies
​

To make DeFi lending protocols secure for all parties, factors below are critical.

• Audits. There are trusted firms that can conduct security audits for smart contracts like CertiK or OpenZeppelin.
• Bug Bounty Programs. White-hat hackers can help DeFi protocols to find vulnerabilities.
• Fail-safes. Mechanisms such as circuit breakers can halt operations when there is suspicious activity.

Real-World Examples of Security Breaches:

• The DAO Hack (2016): One of the most important hacks in the history of smart contracts. Lead to millions in losses.
• Compound Incident (2021): Due to a bug in the update, unintended distributions took place.

The incidents above are important examples to show the importance of security in smart contracts and the world of cryptocurrencies.

Comparison of Blockchain Networks for DeFi Lending

The table above can help you to understand the differences and similarities between the most popular blockchain options in smart contracts. The best one depends on the needs of users. For a user that gives the most importance to transaction speed, Solana would be the best choice. However, for the users who need high decentralization, Etherum would be the best choice.

​As we discovered in this guide so far, De-Fi protocols are in a better position than the traditional financial system. However, you should also know about their potential risks and cons before starting any activity in the DeFi lending protocols. In this section, we will explore both the advantages and disadvantages in detail.

Benefits of DeFi Lending Protocols

​First, we’ll look at the advantages of Lending protocols bring to users, compared to traditional financial instruments.

1. Global Accessibility:

a. The most known advantage of DeFi lending protocols is that you can access the networks wherever you are. Anyone with internet access and a digital wallet can take part in the process.
b. Unlike traditional finance, credit checks and geographical restrictions are not needed.

2. High Liquidity:

a. In order to create vast liquidity reserves, lenders can pool their assets. Borrowers can access these assets easily.
b. Protocol stability is stronger in DeFi thanks to liquidity miming.

3. Lower Costs:

a. Since there are no intermediaries in DeFi lending protocols, overhead costs are significantly lower.
b. Thanks to automated smart contracts, borrowers and lenders can directly interact.

4. Automation and Efficiency:

a. Smart contracts can handle interest calculations, collateral management and loan issuance with only minimal delays.
b. Human error is completely eliminated in the process.

5. Enhanced Yield Opportunities:

a. Returns for lenders are mostly higher than traditional banking systems.
b. Borrowers do not need to sell holdings to main liquidity by leveraging assets like stablecoins.

6. Transparency and Security:

a. Blockchain is completely transparent and verifiable.
Parties can trust the loan terms as they are outlined in the smart contract.

Benefits in Summary

• Participation does not require permission.
• Users can earn passive income through lending.
• Users do not need to rely on the traditional financial system.

Risks of DeFi Lending Protocols

​We’ve explored the potential benefits of DeFi lending protocols compared to traditional finance. Now, we can continue with the potential risks & disadvantages.

1. Smart Contract Vulnerabilities:

a. Since smart contracts are code-based contracts, poorly written or unaudited ones can be vulnerable against breaches and bugs.
b. Even if the bug is small, it can lead to losses in high amounts.

2. Market Volatility:

a. Especially when you do not use stable coins, the value of collateral assets can change dramatically in a short amount of time.
b. When/if the value of the selected collateral drops below a certain point, borrowers face liquidation.

3. Regulatory Uncertainty:

a. The regulations are still unclear compared to traditional finance.
b. Since the governments still work on new rules, any new rule that is non-existent yet can impact classification.

4. Lack of Insurance:

a. Contrary to traditional finance, DeFi platforms do not offer insurance in general.
b. There is always a risk of potential losses due to hacks or vulnerabilities in the system.

5. Network Congestion and Fees:

a. Small transactions are mostly uneconomical because of high gas fees.
b. When there is heavy usage, there can be delays in transactions and costs can rise.

6. User Error:

a. There is always a possibility for human error since DeFi platforms require users to manage their private keys and wallets by themselves.
b. If users lose their private keys, this can result in a permanent loss of funds since there is no authority to cover users« loss.

Mitigating Risks

Although there are some risks and disadvantages, there are always some methods to ensure the reliability and security of DeFi lending protocols.

For Developers:

• Developers should conduct audits to test the safety using relevant tools.
• Developers must build multi-layered security systems that can halt the process when there is something suspicious.
• Build dynamic liquidation thresholds since the market is volatile.

For Users:

• To reduce the risk of liquidation, users should diversify collateral.
• Users should only use platforms with proven security records.
• Users must stay informed about the protocol updates.

Risk Comparison of DeFi vs. Traditional Lending

​A table would be beneficial again to compare risks in the DeFi lending protocols and traditional lending.

​As we discovered in this guide so far, De-Fi protocols are in a better position than the traditional financial system. However, you should also know about their potential risks and cons before starting any activity in the DeFi lending protocols. In this section, we will explore both the advantages and disadvantages in detail.

Benefits of DeFi Lending Protocols

​First, we’ll look at the advantages of Lending protocols bring to users, compared to traditional financial instruments.

1. Global Accessibility:

a. The most known advantage of DeFi lending protocols is that you can access the networks wherever you are. Anyone with internet access and a digital wallet can take part in the process.
b. Unlike traditional finance, credit checks and geographical restrictions are not needed.

2. High Liquidity:

a. In order to create vast liquidity reserves, lenders can pool their assets. Borrowers can access these assets easily.
b. Protocol stability is stronger in DeFi thanks to liquidity miming.

3. Lower Costs:

a. Since there are no intermediaries in DeFi lending protocols, overhead costs are significantly lower.
b. Thanks to automated smart contracts, borrowers and lenders can directly interact.

4. Automation and Efficiency:

a. Smart contracts can handle interest calculations, collateral management and loan issuance with only minimal delays.
b. Human error is completely eliminated in the process.

5. Enhanced Yield Opportunities:

a. Returns for lenders are mostly higher than traditional banking systems.
b. Borrowers do not need to sell holdings to main liquidity by leveraging assets like stablecoins.

6. Transparency and Security:

a. Blockchain is completely transparent and verifiable.
Parties can trust the loan terms as they are outlined in the smart contract.

Benefits in Summary

• Participation does not require permission.
• Users can earn passive income through lending.
• Users do not need to rely on the traditional financial system.

Risks of DeFi Lending Protocols

​We’ve explored the potential benefits of DeFi lending protocols compared to traditional finance. Now, we can continue with the potential risks & disadvantages.

1. Smart Contract Vulnerabilities:

a. Since smart contracts are code-based contracts, poorly written or unaudited ones can be vulnerable against breaches and bugs.
b. Even if the bug is small, it can lead to losses in high amounts.

2. Market Volatility:

a. Especially when you do not use stable coins, the value of collateral assets can change dramatically in a short amount of time.
b. When/if the value of the selected collateral drops below a certain point, borrowers face liquidation.

3. Regulatory Uncertainty:

a. The regulations are still unclear compared to traditional finance.
b. Since the governments still work on new rules, any new rule that is non-existent yet can impact classification.

4. Lack of Insurance:

a. Contrary to traditional finance, DeFi platforms do not offer insurance in general.
b. There is always a risk of potential losses due to hacks or vulnerabilities in the system.

5. Network Congestion and Fees:

a. Small transactions are mostly uneconomical because of high gas fees.
b. When there is heavy usage, there can be delays in transactions and costs can rise.

6. User Error:

a. There is always a possibility for human error since DeFi platforms require users to manage their private keys and wallets by themselves.
b. If users lose their private keys, this can result in a permanent loss of funds since there is no authority to cover users« loss.

Mitigating Risks

Although there are some risks and disadvantages, there are always some methods to ensure the reliability and security of DeFi lending protocols.

For Developers:

• Developers should conduct audits to test the safety using relevant tools.
• Developers must build multi-layered security systems that can halt the process when there is something suspicious.
• Build dynamic liquidation thresholds since the market is volatile.

For Users:

• To reduce the risk of liquidation, users should diversify collateral.
• Users should only use platforms with proven security records.
• Users must stay informed about the protocol updates.

Risk Comparison of DeFi vs. Traditional Lending

​A table would be beneficial again to compare risks in the DeFi lending protocols and traditional lending.

​So far, we’ve learned how DeFi lending protocols work, which platforms and coins are used in the process, what are the advantages and risks especially compared to traditional financial systems, and more. Now, it is time to talk about the technical aspects of the process a bit. In this section, you’ll find information about the development process of a DeFi lending protocol, and what it takes to develop one.

Planning and Ideation

As with any successful process, a successful DeFi landing protocol begins with a good plan. Before starting to develop a smart protocol, you should consider the points below.

Identify the Target Audience

Not all contracts appeal to the same audience. Decide on your target audience. (e.g., retail investors, institutional clients, or crypto traders). Consider the demand on the market.

Define Unique Features

Users will be more likely to choose the contract if it offers:

• Multi-collateral support.
• Lower thresholds for collateralization
• Various and flexible repayment options.

Choose a Blockchain Network

You should consider critical factors such as scalability, transaction fees, and network popularity when choosing a blockchain network. As we mentioned above, Ethereum, Solan,a and Binance Smart Chain are popular options and they have their own pros/cons.

Conduct Market Research

Work on understanding user behavior in existing platforms like Aaave and Compound. Be informed about regulations in the target region.

Development Process

The development process of a DeFi lending protocol is as follows.

Blockchain Setup

First, you need to select the blockchain where your protocol takes place. Then, set up development environments. You can use tools like Truffle (for Ethereum) and Anchor (for Solana)

Smart Contract Development

In order to manage lending pools, interest rates, collateral and liquidation, you need to develop the core smart contracts. You need to leverage a programming language like Solidity for Etherum, or Rust for Solana.

Front-End Development

To offer a seamless UI to users, you need to create an intuitive user interface. You can use libraries like Web3.js or Ethers.js.

Security Testing and Auditing

To find out vulnerabilities in the smart contract protocol, conduct extensive testing. To validate the code, you can partner with third-party audit firms.

Deployment

Deploy smart contracts on the mainnet. For transparency and monitoring, you can use blockchain explorers.

Costs and Timeframes

Of course, there are both fixed and variable costs you’ll face when developing a lending protocol.

Estimated Costs:

• Development Team: $100,000–$300,000 would be a plausible amount for hiring developers, designers, and auditors.
• Smart Contract Audits: $15,000–$50,000 for each audit.
• Blockchain Gas Fees: Depends on the network (e.g., Ethereum is more expensive, while others like Polygon are cheaper).
• Marketing and User Acquisition: $20,000–$100,000, based on campaign scale.

Estimated Timeframe:

• Planning and Research: Takes about 2–3 months generally.
• Development and Testing: Approximately 6–12 months.
• Post-Launch Optimization: Ongoing.

Post-Launch Considerations

After your protocol goes live, maintaining and improving its performance is the most important factor for long-term success.

Monitoring Performance

You need to track key metrics like total value locked (TVL), daily active users (DAU), and loan-to-collateral ratios. To measure user engagement and optimize features accordingly, you need to use analytics tools.

Security Updates

Test your platform frequently against vulnerabilities. Use community-driven bug bounty programs.

Community Engagement

Implement an active management system where token holders evaluate the updates in a positive or negative way. Develop an onboarding process to onboard new users seamlessly.

Iterative Development

To keep your users on your system you need to add new features frequently. Increase the number of supported tokens to include popular assets.

A Step-by-Step Development Summary

1. Conduct market research and find your target audience.
2. Choose a blockchain network.
3. Work on the core smart contacts and the front end.
4. Conduct tests regularly to make sure everything is secure.
5. Launch the protocol and work on marketing.
   Monitor performance, and update the platform if needed.

As you can see, developing a De-Fi lending protocol requires patience, planning and dedication. It seems hard, but if you are dedicated enough and have the required technical capacity, you can develop your own decentralized finance space.