DeFi lending protocols: how they work and the risks
A DeFi lending protocol lets people lend and borrow crypto without a bank. Smart contracts set rates and can liquidate a loan that falls short.
Vahe HakobyanEditor-in-chief
Updated Oct 6, 20263 min readFact-checked
On this page
- Rates come from supply and demand in the pool.
- Lend for interest or borrow without selling.
- Falling collateral can trigger a liquidation.
It runs on smart contracts. A smart contract is a program on a blockchain that holds the rules a bank would enforce.
How does DeFi lending work?
Lenders deposit crypto into a pool a smart contract controls. Borrowers post collateral worth more than the loan, and rates come from supply and demand in the protocol.
How do people use DeFi lending?
People use these protocols to earn interest on crypto they hold or to borrow against it without selling. The borrower keeps the asset.
- Earn interest on crypto you hold.
- Borrow against crypto instead of selling.
- Access cash while keeping the asset.
What risks does DeFi lending carry?
A borrower's main risk is liquidation. If collateral falls below the required ratio, the protocol can sell it. Lenders can lose deposits to hacks and coding errors.
How is it different from a bank?
A bank holds deposits as a regulated business, and eligible accounts carry FDIC insurance. DeFi lending does not follow KYC and AML rules, and some sites block US users.
Frequently asked questions
Usually not at the protocol level, because it does not follow KYC and AML rules. A site may still block US users.
A hack can drain a pool, and lenders may lose part or all of their deposit.
The IRS treats cryptocurrency as property, so interest you earn is usually ordinary income when you receive it.
As a lender, your loss is usually limited to your deposit. As a borrower, you can lose your collateral and still owe remaining debt.
