How do crypto lending and borrowing work?

Crypto lending lets people earn interest by supplying coins and lets others borrow against crypto they already own. Almost every loan is backed by collateral worth more than the amount borrowed. If that collateral loses too much value, it is sold to repay the lender.

How does a crypto loan work?

A borrower deposits one asset and takes out another. Someone might lock up ether worth $150 and borrow $100 in stablecoins, which are tokens pegged to the dollar. The loan is over-collateralized, meaning the security is worth more than the debt.

That cushion replaces the credit check. The lender usually does not know who the borrower is and has no way to chase them. The collateral is the only protection.

People borrow this way to get spending money without selling their coins, or to make larger bets on prices. Lenders are depositors who want a return. Interest rates are not set by a committee. They move by formula as demand for loans rises and falls.

What is liquidation?

Each loan has a threshold. If the collateral's market value falls to that level, the loan can be liquidated. Part or all of the collateral is sold, the debt is repaid and the borrower is charged a penalty.

In DeFi, this happens automatically. A price feed called an oracle tells the lending program what the collateral is worth, and outside traders are paid to close out unsafe loans. There is no phone call and no grace period. In a sharp market fall, many loans are liquidated within minutes, and the forced selling can push prices down further.

DeFi programs vs lending companies

There are two broad models.

DeFi lending programs, such as Aave and Compound, are smart contracts. The rules, the collateral and the loans are visible on the blockchain. The main danger is a flaw in the code or in the price feed.

Centralized lenders are companies. Customers hand over their coins, and the firm decides where to lend them. Celsius, Voyager and BlockFi grew quickly on this model by advertising high interest on deposits. Customers could not see how the money was used, and some of it went into large loans to trading firms with little or no collateral.

When prices fell in 2022, those bets failed. Celsius froze withdrawals in June 2022 and filed for bankruptcy the next month, as did Voyager. BlockFi followed in November 2022, after the collapse of FTX. Customers found they were creditors in a bankruptcy case, not depositors who could withdraw on demand.

What are the risks?

• Liquidation. A borrower can lose collateral quickly in a falling market.
• Platform failure. A lending company can become insolvent, and a DeFi program can be hacked.
• No insurance. These accounts are not bank deposits. See whether crypto is insured.
• Changing rates. The interest earned or owed can shift from day to day.