Undercollateralized & Collateralized Loans
What are Undercollateralized Loans ?
Loans which are not secured or insufficiently secured are known as "uncollateralized" loans in in DeFi they are also referred as "flash" loans. These kind of loans either do not require any collateral or collateral offered is less as compared to the loan which is borrowed. Such loans are very rare in traditional systems but in DeFi such loan can be secured by the smart contract that oversaw the protocols which are lending. Many DeFi protocols lend the borrower a certain amount of a specific cryptocurrency, like stable coins or Ethereum, for a very short period of time, usually one block or less. The amount is almost equal to the asset locked in contract i.e. If 1 ETH is $2500 loan amount borrowed is $2500 USDC. Borrowers who borrow such loans usually use the amount for flash trading for making quick money and they repay the loan, plus interest, before the end of that block. In these cases the asset is locked in a smart contract which automatically liquidates the borrower’s assets if the loan is not repaid on time. Flash loans are very famous with traders who use it to make quick money.
Example of an Undercollateralized loans in DeFi
User wants to borrow 10,000 USDT to make a trade.
User interacts with a lending protocol that offers undercollateralized loans, such as Aave or Compound and deposits 4 ETH each of $2500.
User borrows 10,000 against ETH for a period of one block.
User makes their trade and earns a profit of 1000 USDT.
Before the end of the block, the user repays the 10,000 loan plus any interest owned.
User makes profit of 1000 USDT minus interest.
Benefits of undercollateralized DeFi loans
Access to liquidity:
Since the borrower does not need to provide long term collateral, it is easier for them to access loans. This can be especially beneficial for those who do not have assets to use as collateral or who want to avoid losing their assets.
Flexibility:
Undercollateralized DeFi loans are typically available for a very short period, usually one block or less. As a result, borrowers can quickly access and repay the loan to seize market opportunities.
High-leverage trading:
Borrowers can use undercollateralized DeFi loans to access high-leverage levels, increasing their potential trade returns.
Risks of undercollateralized DeFi loans include:
Default risk:
Since the borrower does not need to provide collateral, there is a greater risk of default. This means that borrowers may not repay the loan, and the lender may need help to recover their funds.
Liquidation risk:
If the borrower cannot repay the loan, the smart contract may automatically liquidate their assets to repay the loan. This can result in the borrower losing more than just the loaned amount.
Price volatility:
The value of the loaned cryptocurrency can be highly volatile, meaning the loan’s value can change rapidly. This can make it difficult for borrowers to repay the loan and result in losses for the lender.
Smart contract risk:
Undercollateralized DeFi loans are typically governed by smart contracts, which are self-executing codes. If a bug in the code or the contract is exploited, it can lead to a significant loss for the parties involved.
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