Introduction
The rise of financial institutions made it possible for people to do business with each other in a way that was open, safe, and reliable for everyone. On the other hand, as banks and other financial institutions have become more powerful over the course of history, they have taken advantage of their monopolies by charging huge fees for even the most basic financial services and making financial instruments that are hard to understand.
The excessive power that banks held in the financial system contributed to the collapse of the global economy that took place in 2008.
DeFi
The goal of decentralized finance is to provide the same benefits as traditional ways of handling money but to do so without using any middlemen. Because DeFi uses the smart contract technology of the blockchain network, which eliminates the need for human intervention and reduces the chance of mistakes, the financial system can be more efficient overall.
Most DeFi projects have made their original source code available to the public for free. Clarity and transparency are both increased as a result of this.
Let’s say you currently have 100 DAI in your wallet; MetaMask or another online exchange. DAI holders who deposit their coins into the “reserve pool” of DeFi protocols like Aave will earn interest on their holdings.
Instead of giving Aave access to your private crypto, you are putting your faith in the security of the smart contracts they’ve developed, where you will be given tokens. Those tokens stand in for the deposited cryptocurrency. These tokens are similar to bonds in that they are backed by a program that promises to pay interest and return the initial investment if and when the tokens are redeemed. You can put them in the “reserve pool” of DeFi protocols like Aave and be able to accrue interest on your holdings.
The resources of depositors are pooled together to enhance the size of a lending pool, which is then used by borrowers to draw loans. The only prerequisite for prospective borrowers in these pools is the provision of collateral. To meet the over-collateralization criteria, you have to put up more cryptocurrencies as collateral.
As Per DeFi’s Limits
One of the main problems with Defi is that it can be hard for new users and the general public to use decentralized products because the user experience and interface are so complicated. Any long-term business strategy needs to deal with this problem because a growing number of users is essential to the success of the strategy. It is quite improbable that the average person who uses financial services will be concerned with phrases like “layer one” and “layer two.” This does nothing but make it more difficult for the user to switch to DeFi.
There is no doubt that DeFi is expanding at a lightning-fast pace. The total market value that has been locked up (TVL) keeps increasing. Yet, an issue for DeFi is that many of its assets are not being used as well as they could be. There are a lot of lenders but a much smaller number of borrowers. The Defi Protocol utilization rate is low.
What can be done to increase the number of borrowers in relation to the lenders?
Is the over-collateralization model hindering the rate at which people borrow? If that’s the case, this is an example of a situation where the Soulbound token could be helpful. With SBTs, collateralization may not be necessary because each user can be digitally identified.