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Aave, Compound and MakerDAO: DeFi lending protocols compared

November 4, 2021

7 min

Aave, Compound and MakerDAO: DeFi lending protocols compared

One of the most interesting services of decentralised finance (DeFi) is lending. Let’s find out how platforms like Aave, Compound and MakerDAO work and what distinguishes them from traditional loans.

Traditionally, when applying for a mortgage or loan, the intermediary you rely on is a bank, which has the authority to approve or reject an application.

In the cryptocurrency sector, there are both centralised (CeFi) and decentralised (DeFi) solutions.

CeFi solutions are e.g. Blockfi or Nexo, which take custody of deposited cryptocurrencies or fiat currencies and lend them to institutional players such as market makers, hedge funds, or other platform users. These platforms require identity verification and are regulated, but have no other requirements.

In DeFi, on the other hand, there are some protocols on blockchain that allow loans to be requested or granted in a decentralised way, thanks to specially developed smart contracts.

MakerDAO, Aave and Compound are the founding protocols of this sector, which have held the record for total value locked (TVL) for most of the time.

DeFi lending was born with MakerDAO in 2018, but took off with DeFi in summer 2020.

How DeFi lending works

In general, lending protocols allow:

  • Lend: depositing your cryptocurrencies in the protocol in exchange for a constant percentage reward.
  • Borrow: generating a cryptocurrency loan by depositing collateral in another cryptocurrency and paying a percentage.

All this, in a decentralised way, i.e. without a financial intermediary. Loans are regulated by smart contracts and recorded on blockchain.

Lenders deposit their tokens in liquidity pools or similar smart contracts. From these same pools, borrowers borrow tokens.

How APY and APR work

The percentage received by the lender is the same as that paid by the borrower, and is called APY or APR.

The APY (Annualised Percentage Yield) is the effective rate of return on an investment in one year.

The APR (Annual Percentage Rate) is the percentage of interest you will earn in a year, not including compound interest.

Even if the operations made in the field of DeFi are not actual investments, these terms are often used on lending and yield farming platforms.

The APY of decentralised loans is generally higher than what we are traditionally used to, it is also variable and in cases of increased demand it can rise by several tens of percentage points. This is a risk for borrowers, but a great advantage for lenders.

How collateral works

In the main DeFi protocols today, borrowers of liquidity have to over-collateralise their loan. So to get a loan of e.g. 100 DAI, it is necessary to deposit more than 100$ of ETH.

Why then take out a DeFi loan?

Some traders use this service because it allows them to have instant liquidity without having to sell cryptocurrencies that they think are convenient to “hold”.

Holding cryptocurrencies can be part of a strategy to continue to benefit from the services of staking or providing liquidity, while in the case of professional traders it can be a way of maximising market positions or part of an arbitrage technique.Over-collateralisation also ensures that lenders will be paid back.

This mechanism is very simple with stablecoins, while some problems arise when a volatile cryptocurrency is involved in lending. If the deposited collateral falls in price so much that its value is no longer proportional to that of the loan generated, it will be sold by the protocol. To avoid this, you can feed your collateral over time if the cryptocurrency gives signs of going down.

The main lending protocols compared

MakerDAO, Aave and Compound are three “historical” protocols for DeFi lending and are all based on Ethereum. Their ERC-20 tokens are MKR and DAI, AAVE and COMP respectively.

Aave and Compound are more similar to each other:

  • Lenders receive their rewards in aTokens (Aave) and cTokens (Compound).
  • They both take cryptocurrency prices from Chainlink oracles
  • Unlike MKR, AAVE and COMP can be “staked” or “mined”, so by locking these tokens, new ones can be generated.

Meanwhile, Aave has 2 main innovative features:

  1. Flash loans, loans that are generated and repaid instantly.
  2. The ability to receive or pay a stable APY

In addition, it has a wider range of tokens and pairs than Compound.

Compound for its part is developing a unique new element: its own blockchain to facilitate cross-chain lending, i.e. between different blockchains.

TradFi Lending vs DeFi Lending

Let’s summarise the differences between a normal loan and a DeFi loan in order to deduce the pros and cons of this innovation.

Any type of loan (except a flash loan) requires a collateral or guarantee.

In traditional finance (TradFi) this collateral is creditworthiness, and obtaining a loan requires:

  1. age between 18 and 70.
  2. a demonstrable income
  3. residence in the territory in which you are applying
  4. be an account holder at the credit institution from which the loan is applied for
  5. The loan can be repaid with interest over a period of weeks, months or years
  6. Can only be generated in fiat currency

While DeFi loans:

  1. Do not require identity verification or income data
  2. Do not require a bank account
  3. They are instantaneous
  4. Decentralised and therefore global and without censorship or restrictions
  5. Require a collateral deposit covering more than 100% of the requested loan
  6. Can only be generated in cryptocurrency

Aave has made a third choice, by integrating the TradFi system. Aave remains a decentralised protocol, however it also offers the possibility of using Transak to purchase cryptocurrencies by credit card and use the cryptocurrencies purchased directly in Aave’s pools.

Making use of this integration naturally requires identity verification. On the other hand, however, it brings DeFi closer to the inexperienced user.