An Introduction to Crypto Lending and Borrowing
New to Crypto or Decentralized Finance (DeFi)? Want to better understand crypto lending and borrowing? Not so new, but everything you read is confusing?
Trying to learn crypto lending and borrowing can be a convoluted experience for new users, especially when advanced strategies like leverage are in the mix. But fear not — Archimedes is breaking it down for you!
Let’s start with some fundamentals. Crypto is built on blockchain technology — if you’re not familiar with blockchain or cryptocurrency, we recommend that you read this article before continuing.
Now you know the basics of cryptocurrency, let’s talk about some basics of finance: collateral.
A brief explanation of collateral
In traditional finance, collateral is an item of value that a lender can seize from a borrower if they fail to repay a loan according to the agreed terms. When a borrower applies for a loan, they provide assets they own in the form of collateral, and as long as the borrower is able to repay their loan, their collateral remains under their ownership. If they fail to repay their loan, their collateral is used as a form loan payment and its ownership is transferred to the lender. For example, when someone gets a loan to buy a house, their house is the collateral to that loan and if they fail to pay the lender, the house ownership is then transferred to the lender as payment and the borrower loses their house.
In Crypto, collateral is not different. When a borrower provides collateral, they typically provide it in the form of tokens, or simply put, digital currency.
What are tokens?
There are many digital currencies (or tokens) out there. You may have heard of the tokens Bitcoin or Ether, the two biggest tokens. The Bitcoin token is built on top of the Bitcoin Blockchain, while Ether is built on top of the Ethereum Blockchain.
That’s where things start to get interesting. In addition to Ether, there are several other tokens built on top of the Ethereum Blockchain. Two of the largest tokens on the Ethereum Blockchain, besides Ether, are USD₮ (“printed” by Tether) and USDC (“printed” by Circle). They are both tokens that are engineered to be at 1:1 value with the US Dollar.
You may be wondering; how is it possible to have “versions of US Dollar” that are digital? Is that real money? The answer is yes!
Like any real world assets, digital currencies are backed (or collateralized) by some type of asset that has intrinsic value. USD₮ was backed by commercial papers and now is fully collateralized by T-Bills and USDC is backed by US Dollar. Each token uses different forms of collateral to guarantee value. Collateral is also how they maintain “peg” (or a 1:1 relationship) with the US Dollar. For example, USD₮ is fully backed by collateral. It has maintained its peg because every USD₮ is redeemable for dollars.
Not all tokens use this approach. Instead, some of them use algorithms to ensure they stay pegged to the dollar. There are downsides to this; these “algorithmic stablecoins” are not as popular or as widely accepted. If you want to read more about the downsides to algorithmic stablecoins, we recommend checking out the UST and Terra Luna case study.
USDC and USD₮ are what we call “collateralized stablecoins” in crypto. They unlock a great deal of new financial technologies together with liquidity pools, from projects such as Curve Finance.
What are liquidity pools?
We’ll keep this overview short, but you can read much more here — we encourage anyone wanting to learn DeFi to dive really deep into liquidity pools, and Curve Finance is the place to start. Curve Finance allows people to trade cryptocurrency in an efficient way. It pairs digital assets, such as USD₮ and USDC, in “pools” with around 50% of each token present. These liquidity pools can be used to swap a token for another. Say you have $100 worth of USDC and want to swap for USD₮ — you can go to the USDC/USD₮ liquidity pool in Curve and swap one for the other.
Where do these pools come from? Anyone can provide money to a liquidity pool to get an interest on that money — this activity is also called “liquidity providing”. We will explain how liquidity providers get paid for lending their money.
Projects typically create pools with different pairs of assets to facilitate their own lending and borrowing process, with one side being typically a widely adopted token such as ETH or USDC and the other their own token. This way the protocol has liquidity available to enable their borrowing process. Curve is one and largest example, but there are several different platforms that create liquidity pools.
At Archimedes, we have created a pool pairing 3CRV with lvUSD. 3CRV combines the three major US Dollar pegged stablecoins (USDC, USD₮, and DAI), and lvUSD is Archimedes’ own collateralized stablecoin. We fill this pool with assets coming from lenders / liquidity providers. We then use the assets sitting in that pool to lend to borrowers, which they can then use for one purpose: to get quality leverage with Archimedes.
What is leverage? Why would I want to use it?
Leverage is an existing financial strategy that is made easier with technology. The practice entails borrowing a certain amount of money at a certain cost and investing it for a return that is higher than the cost of borrowing. That way, the borrower can make a profit on the borrowing amount, i.e., money that they don’t own. Clever, right?
With Archimedes, the borrower deposits collateral in the form of a stablecoin, OUSD, from our launch partner Origin Protocol. This allows them to access up to 9x lending on that collateral in the form of lvUSD, which Archimedes swaps to OUSD via our 3CRV / lvUSD and their 3CRV / OUSD pool. Because OUSD appreciates by a certain percentage (or APY), borrowing up to 9x what they provided as collateral allows the borrower to make up to 10x (9x borrowed + 1x collateral) on the APY from that stablecoin.
Let’s use an example to illustrate it. Let’s say you have $1,000 worth of OUSD. You deposit that collateral with Archimedes for a fee, then Archimedes will borrow $9,000 worth of lvUSD from the pool. We then swap that $9,000 for the same currency you deposited as collateral, OUSD. Now you own a position of $10,000 worth of an appreciating stablecoin, which results in 10x the return on initial $1,000. Once you decide to close the position, you will receive your $1,000 worth of OUSD back with the OUSD generated from the yield.
How can a stablecoin grow in value?
Stablecoins typically do not appreciate relative to the US Dollar, but some crypto projects use strategies to put that money to work. Our launch partner, Origin Protocol, “prints” OUSD, an overcollateralized US Dollar pegged token. They then lend the OUSD to make some interest and that’s how it grows in value.
At Archimedes, we will be launching soon with OUSD leverage positions, but any appreciating like-asset could be used on the platform to help users get up to 10x gains.
As mentioned above, borrowers pay a fee to access leverage. They will also pay a performance fee on their proceeds from the leverage position. With these fees paid by the borrowers, Archimedes is then able to close the loop and pay the lenders for lending their money. It’s a win-win situation for all parts involved: lenders, borrowers, Archimedes Finance, Origin Protocol (or any future partners).
We hope this was helpful for you to understand DeFi lending and borrowing and Archimedes a little better. This is just an introductory article and there is a lot more to it, but now you will be equipped to start reading the more advanced articles and content about Archimedes and DeFi.
We invite you to join us in Twitter, Discord, Telegram, and read more in our more advanced Medium posts to learn more. We are always there to answer any questions you may have about our product and DeFi in general.
Archimedes is an experimental protocol and carries significant risks: Smart contract risk, economic model risk, risk that the assets Archimedes introduces and many other types of known and unknown risks. Archimedes’ team never provides investment advice. This article is NOT financial advice. DYOR. Participate at your own risk.