What are DeFi Lending Protocols, and How do They Work?

It is no surprise that Decentralized Finance has been on an explosive run in recent years, and it is easy to see why.

A recent report by CNBC outlined that nearly half of the worlds millennial millionaires have at least 25% of their total net worth in Cryptocurrency and DeFI projects, and this is trend is likely to continue at an exponential rate. These young, bright, and wealthy entrepreneurs are the leaders of tomorrow, and if they have confidence in the future of Cryptocurrencies and DeFI, this means that the empires that they are building today will likely integrate in some way with the digital finance technology of tomorrow.

It is nearly impossible to ignore the lucrative investment opportunities in massive projects like Aave and Compound Finance, two of the leaders in the Decentralized Finance space which, according to DeFi Pulse, hold a mind-numbing $15 billion and $11 billion dollars respectively, currently locked into their protocols at the time of writing.

It is incredible to think that Aave was created as recent as 2017, and there has already been 15 billion dollars’ worth of funds locked into the protocol, paying investors a healthy variable rate anywhere from 0.5% APY all the way to the blistering 691% currently offered on riskier assets such as Ampleforth.

Decentralized Finance is accessible and open to anyone with an internet connection, with no greedy middleman taking a cut or opening investors up to counterparty risk, so it isn’t hard to see why investors have flocked to these protocols. Also fuelled by the fact that people have been putting up with decades of banks offering their clients insultingly low ROI’s that don’t even manage to outpace inflation, investors have been desperately waiting and in need of better opportunities. The entire financial industry was in serious need of an overhaul, which is how DeFI has exploded in popularity, coming onto the scene with all the shiny, cape-wearing splendour of a superhero arriving just in time to save the day.

Early investors into Aave, without even partaking in the interest-bearing APY, would have been able to buy into the token itself at around $40 dollars per coin, with the all-time high shooting up to $648 per coin! That is an insane 1,520% return on your investment without lifting a finger. Couple that with the on average 10%-20% APY you can earn on top of that just by lending your coins out in the Aave protocol, and you are now hitting the kinds of numbers that traditional investors can only dream of. Much better than the half a percent you might get from your traditional financial institution if you’re lucky. Even the top hedge fund and stock portfolio investors in the world struggle to consistently make 10% ROI per year, and that is before they take their cut.

No thanks, I think I’ll stick with DeFI.

But how do these lending protocols actually work?

DeFi lending platforms offer crypto loans to borrowers through a permissionless process. These loans are provided by crypto holders who are happy to offer their crypto up for users to borrow, of course, with interest charged. In the traditional financial industry, such deals are facilitated by a third party such as a bank or lending institution who take a cut.

DeFi protocols connect everyday lenders and borrowers such as you and me, across a decentralized ecosystem. Within these protocols, the users maintain control over their funds with trade agreements executed using smart contracts built on open blockchain solutions.

The idea of DeFi was born out of the necessity to have a transparent and open financial industry, free of manipulation and safe for users. DeFi is quickly becoming the clear winner as the leading decentralized lending system, allowing lenders to earn interest on their crypto, while borrowers can easily borrow funds, all happening without an intermediary.

Let’s get into some specifics on how these actually work. We will start with Aave as they are the largest lending protocol in terms of funds locked in.


Aave attempts to solve the challenges faced in the traditional financial industry in the borrowing and lending sector. They do this by converting traditional financial services over to their decentralized equivalents. The biggest difference here is that the Aave protocol allows for the interest earned to go towards the individual lender, instead of the lending institution.

The Aave protocol allows anyone to lend and borrow crypto assets in a trustless and permissionless way, with interest being paid directly into the lender’s wallet address. Lenders place their money into liquidity pools where borrowers can borrow from. Lenders are able to exit the lending pool at any point. The borrowers must deposit enough credit, more than the amount borrowed, with the Aave protocol setting a collateralization ratio that borrows must maintain. If they fail to do so, their deposit may be liquidated.

Compound Finance

Compound Finance works in a similar way to Aave. The lending platform allows users to exchange crypto assets while earning interest if they lend out their coins in liquidity pools.

The lending protocol utilizes smart contracts to store and manage pooled capital which users can access by connecting their web wallets and earn interest in the form of Compound Finances’ cTokens.

Compound Finance is the largest Decentralized Autonomous Organization (DAO) meaning it is completely community-driven, running autonomously outside of any controlling body. This gives users further trust in the platform as there is no third-party risk, meaning there is no company overlooking the operations here that could go bankrupt, lose the funds, or fall under governmental scrutiny.

While cTokens are what users receive for lending their assets, the protocol also utilizes the COMP token which is used as a governance token, allowing users to have voting rights on any proposed changes that will affect the protocol, keeping the interest of what is best for the protocol in the hands of the community members.

Cream Finance:

Cream finance is also worth a mention here as it was created as a fork from Compound Finance on August 3rd, 2020 on the Ethereum network. Similar to Aave and Compound Finance, Cream Finance has also launched a version of the protocol on the Binance Smart Chain, polygon, and Fantom networks. Cream finance allows for peer-to-peer lending, staking and borrowing, and works very similar to its parent Compound Finance. The biggest advantage here is that by running on the Binance Smart Chain, users can perform all the same lending, exchanging, borrowing, and staking transactions without the hefty Ethereum network fees that have been plaguing users as everyone waits for the highly anticipated release of Ethereum 2.0

Sheesha Finance:

There are more ways to earn money in DeFi than just lending and borrowing though. This is what makes new visionary initiatives from platforms like Sheesha Finance so exciting in the DeFi space.

The possibilities and opportunities in DeFi are endless, and that is what companies such as Sheesha Finance are taking advantage of, offering the first of its kind DeFi mutual fund that allows anyone the opportunity to become an early investor in new DeFi projects, giving everyone the chance to become a venture capitalist, while providing investors with portfolio diversification and rewards.

Users who get involved with Sheesha Finance partake in what is called Liquidity Generation Events (LGE’s) where they can contribute Ethereum or BNB and receive Liquidity Provision tokens (LP’s) in return. Users then have the option to stake these tokens on the Sheesha Finance platform where the tokens are used to generate the liquidity and cash flow needed for premium start-up DeFi projects who partner up with Sheesha Finance. Users who stake their LP tokens get paid out rewards in the form of the tokens generated by these high-quality DeFi projects in the hopes that these projects will do well and their token values will increase. This is the first project of its kind that allows average users to partake in early coin offerings by projects and companies that used to only be available to an elite few, and it is these early coin offerings that generate some of the highest returns seen in crypto.

Closing thoughts:

There is no question that the traditional financial system is not living up to the needs and wants of this new generation of investors, which has led to the massive growth of the DeFi space. Years of scandals, mistrust and insultingly low-interest rates have left people looking for alternatives. Just as Netflix caused the fall of Blockbuster, Uber is taking market share from conventional taxi’s every day, Airbnb is dominating the hotel industry, could DeFi be the thing that takes down the traditional financial system? I guess only time will tell, but in the meantime, investors are happy to be earning passive income on the journey.

Sheesha Finance is one of the hottest projects in DeFi, bringing together a complete one-stop-shop for all decentralized finance needs.