What is DeFi lending and how does it work?

DeFi lending promises open access to borrowing and lending. But the mechanics are anything but simple. Behind the headlines are smart contracts, collateral rules and automated liquidations that can work quickly and unforgivingly.

This guide breaks down how DeFi lending actually works and everything else you need to know.

But first, here’s a glossary of common terms for this particular corner of crypto, to further aid in your understanding.

Common DeFi lending terms to know

 What is DeFi lending?

Decentralized finance (DeFi) lending is a way to borrow and lend crypto assets without traditional intermediaries such as banks or brokers. Instead of institutions setting terms and holding funds, DeFi lending relies on software running on public blockchains.

These systems are powered by smart contracts – self-executing programs that apply predefined rules automatically. They manage deposits, loans, interest calculations and liquidations, doing away with much of the manual oversight or trust in a central party.

Most DeFi lending doesn't happen directly between individuals. Instead, users interact with protocols that pool liquidity from many participants. Lenders supply assets to these pools, while borrowers access them by posting collateral under conditions set by the protocol.

DeFi lending vs. traditional lending

Traditional lending relies on centralized institutions to assess the creditworthiness of applicants. Geography, identity requirements and credit history are common restrictions and processes can involve delays or manual approval.

DeFi lending removes many of such barriers, while introducing different forms of risk. As participation is permissionless and more accessible, the onus is on users to take on more responsibility for managing risks themselves.

DeFi lending vs. centralized crypto lending

Centralized crypto lending platforms act as custodians, holding user funds and setting lending terms internally. Users rely on the platform’s operational controls and financial health.

DeFi lending protocols, by contrast, allow users to retain control through on-chain interactions. Rules are encoded in smart contracts and visible on the blockchain, though this also means users are exposed directly to protocol-level and market risks.

How does DeFi lending work?

At a high level, DeFi lending operates through smart contract–managed liquidity pools. Lenders would deposit their crypto assets into these pools for borrowers and receive compensation determined by protocol-defined mechanisms in return.

Borrowers access funds by locking up collateral, usually worth more than the amount borrowed. This overcollateralization helps protect the system from price volatility and is a core design feature of most DeFi lending protocols.

What are DeFi lending pools?

DeFi lending pools are shared reserves of crypto assets supplied by many users. Instead of matching lenders and borrowers individually, the protocol allows borrowing from the pool as long as collateral requirements are met.

This pooled structure improves liquidity availability and allows loans to be issued continuously, without waiting for a specific counterparty.

How interest rates are determined

Interest rates in DeFi lending are usually algorithmic. They adjust automatically based on supply and demand within each pool.

When borrowing demand rises relative to available liquidity, rates tend to increase. When liquidity is abundant and borrowing slows, rates generally decrease. These changes are visible on-chain and update in real time.

What is overcollateralization?

Overcollateralization refers to the requirement that borrowers deposit collateral worth more than the amount they wish to borrow. For example, borrowing $100 worth of assets may require locking up $150 or more in collateral.

This buffer helps protect lenders if market prices move against the borrower, but it also means borrowers must actively manage their positions.

What triggers liquidation?

If the value of a borrower’s collateral falls below a protocol-defined threshold, the position may become eligible for liquidation. When this happens, the smart contract can sell part or all of the collateral to repay the loan and protect the lending pool.

Because this process is automatic and price-driven, managing collateral ratios is central to using DeFi lending responsibly.

Types of DeFi lending models

1. Pool-based money markets

Pool-based lending is the most common DeFi lending model. Users supply assets to shared liquidity pools, which borrowers can draw from as long as they meet collateral requirements.

Interest rates are set algorithmically based on pool utilization. This model supports continuous lending and borrowing without requiring direct matching between individual lenders and borrowers.

2. Peer-to-peer DeFi lending

Peer-to-peer DeFi lending connects borrowers and lenders more directly. Loan terms such as interest rates, duration, and collateral may be set on a case-by-case basis rather than determined by a pool.

This model is more flexible, but less common due to lower liquidity and the added complexity of matching counterparties on-chain.

3. Flash loans

Flash loans are a DeFi-native mechanism that’s often grouped with lending. Here, users borrow assets without upfront collateral, provided the loan is repaid within the same blockchain transaction.

If repayment doesn’t occur immediately, the transaction is automatically reversed. Flash loans are typically used for advanced activities such as arbitrage or protocol interactions and carry technical and execution risks.

Why borrow and lend in DeFi?

People participate in DeFi lending for different reasons, depending on whether they are borrowing assets or supplying liquidity. 

Common use cases for DeFi borrowing

• Access liquidity without selling crypto assets. For example, users may borrow against existing holdings to manage short-term cash needs or adjust portfolio exposure while remaining on-chain.
• Employ within broader DeFi strategies, such as moving assets between protocols or managing positions without exiting the crypto ecosystem.

Why users provide liquidity to lending protocols

Those who supply assets to DeFi lending protocols help make borrowing possible by contributing to shared liquidity pools.

The eventual returns (whether it’s net positive or negative) reflects market demand for those assets. Participation also allows users to remain on-chain while their assets are in use, rather than sitting idly in a wallet.

DeFi lending vs. centralized lending platforms

DeFi lending and centralized lending platforms both allow borrowing and lending of crypto assets, but they operate on different assumptions about control, custody and risk.

Centralized platforms function much like financial services companies. DeFi lending protocols function more like open systems, where users interact directly with on-chain infrastructure rather than an intermediary.

Key differences at a glance

Understanding the trade-offs of DeFi lending

1. Control vs convenience

Users interact directly with on-chain protocols. It’s more transparent and removes reliance on intermediaries, but also means there is no central party to reverse errors or intervene when things go wrong.

2. Automation vs discretion

Smart contracts apply rules consistently and without bias, but they do so rigidly. Liquidations, for example, are triggered automatically based on predefined thresholds, regardless of market context or user intent.

3. Trust vs independence 

Instead of trusting an institution’s processes and safeguards, users rely on open-source code, protocol design and on-chain data. This can increase transparency, but it also places greater emphasis on understanding how each system works before participating.

How to start DeFi lending

Getting started with DeFi lending usually begins with understanding how assets move from a centralized account into an on-chain lending environment. 

For many users, platforms like Crypto.com act as a bridge, combining account management with access to DeFi lending protocols in a single interface.

Getting started with DeFi lending using the Crypto.com App

Within the Crypto.com App, DeFi lending is accessible through the ‘Earn’ section. From there, you can navigate to ‘DeFi Yield’, then select ‘DeFi Lending’ to view supported assets and available protocols.

A standard flow would look like this:

• Selecting a supported token and entering the amount to supply.
• Reviewing the underlying DeFi protocol and key terms.
• Accepting the applicable disclosures.
• Confirming the transaction to supply assets on-chain.

Once supplied, assets are allocated to the selected DeFi protocol and rewards are distributed according to the protocol’s mechanics. Supplied assets can generally be redeemed at any time, with funds returned to the user’s wallet.

Getting started with DeFi lending using the Crypto.com Exchange

On the Crypto.com Exchange, DeFi lending can be accessed through the ‘Yield’ section under ‘Staking & DeFi’.

From there, you can:

• Choose a supported asset for DeFi lending.
• Specify the amount to supply.
• Review protocol details and on-chain terms.
• Confirm participation through the Exchange.

The exchange interface also allows you to monitor supplied assets and manage redemptions. As with the Crypto.com App, availability of DeFi lending features may vary depending on jurisdiction and supported assets.

Key risks of DeFi lending

Although DeFi lending operates in transparent, market-driven systems, it doesn’t mean that financial and security risks are any less prominent.

1. Smart contract vulnerabilities

DeFi lending protocols rely on smart contracts to manage funds and enforce rules. If a contract contains a flaw or is exploited, assets supplied to the protocol may be affected.

Audits and public code reviews can reduce risk but they don’t eliminate it. Once a contract is live, outcomes are enforced by code rather than a central authority.

One way to mitigate such risks is to choose well-known and reputable platforms that have demonstrated high levels of security. 

2. Market volatility and liquidation risk

Most DeFi loans are overcollateralized, meaning borrowers must lock up more value than they borrow. If the value of that collateral falls sharply, a position may be liquidated.

Volatility also affects lenders. Even if a lending position remains active, declines in the underlying asset’s price may outweigh any returns generated through lending activity.

Liquidations are automated and can occur quickly during volatile market conditions. This makes collateral monitoring a critical part of using DeFi lending protocols.

3. Liquidity risk

DeFi lending depends on sufficient liquidity within lending pools. If many users withdraw assets at the same time, borrowing or redemption conditions may change.

In stressed market environments, this can affect how easily positions can be adjusted or exited, even if protocol rules remain unchanged.

4. Network fees and transaction costs

DeFi lending activity requires on-chain transactions, which can incur network fees. During periods of congestion, higher gas fees may make smaller positions inefficient or delay actions such as adding collateral or adjusting positions, increasing exposure during volatile conditions.

5. Oracle risk

Protocols rely on price oracles to determine collateral values and trigger liquidations. If an oracle provides delayed or inaccurate data, it can lead to unexpected liquidations or pricing discrepancies.

Oracle design varies by protocol and failures are rare but consequential when they occur.

6. Regulatory uncertainty

DeFi lending operates across jurisdictions with evolving regulatory frameworks. Changes in regulation may affect how protocols are accessed, supported or integrated with platforms over time.

Because many protocols are decentralized and global by design, regulatory outcomes can vary by region and remain uncertain.

DeFi lending outlook

DeFi lending is slowly moving out of its experimental phase and into a more selective one. Early growth was driven by novelty and yield, but recent development has focused more on risk management and durability.

Protocols that survive prolonged volatility tend to be those that adapt to changing collateral rules and liquidation mechanisms rather than simply scaling volume.

As participation broadens beyond early adopters, lending interfaces and tooling have begun to emphasize collateral health, liquidation thresholds and protocol exposure, on top of internal improvements on the user experience and interface level.

Although institutional interest in on-chain lending has also grown, typically through controlled pilots rather than open-ended participation, DeFi lending is still subject to changing user demands and trends, on top of macro-level factors and regulations. As a result, DeFi lending is unlikely to follow a single growth path.

Explore DeFi lending with Crypto.com

DeFi lending isn’t plug-and-play finance. The mechanics can be complex compared to spot trading and risks are real. That’s why taking the time to understand it is crucial.

Crypto.com provides an environment where you can learn before participating, demystifying DeFi lending without glossing over its complexity.

• Understand how DeFi lending works, from collateral and liquidation to on-chain risk.
• Explore DeFi tools and protocols with clearer context, not guesswork.
• Manage assets and track positions using integrated interfaces.
• Build knowledge progressively through our Crypto.com Learn library of content.

Get started with Crypto.com.

FAQs about DeFi lending

What is DeFi lending and how does it work?

DeFi lending allows users to borrow and lend crypto assets through blockchain-based protocols rather than centralized financial institutions. Assets are supplied to on-chain liquidity pools and borrowers access those pools by providing collateral. 

Smart contracts manage interest, collateral requirements and liquidations automatically according to predefined rules.

Is DeFi lending safe?

DeFi lending can be used securely but it’s not risk-free. Outcomes depend on factors such as smart contract design, market volatility, liquidity conditions and oracle reliability. Unlike traditional platforms, losses caused by liquidations or protocol failures are typically irreversible, which makes understanding risks essential.

How are interest rates set in DeFi lending?

Interest rates in DeFi lending are usually determined algorithmically. They adjust based on supply and demand within each lending pool. When borrowing demand rises relative to available liquidity, rates tend to increase. When liquidity is plentiful and borrowing slows, rates generally fall.

What happens if collateral value falls?

If the value of collateral drops below a protocol’s liquidation threshold, the position may be liquidated automatically. In this process, some or all of the collateral is sold to repay the borrowed assets and protect the lending pool. Liquidations are triggered by on-chain price data and can occur quickly during volatile markets.

Can beginners use DeFi lending platforms?

Beginners can explore DeFi lending, but it typically requires more preparation than traditional or centralized platforms. Understanding how collateral, liquidation thresholds and on-chain transactions work is important before participating. Many users start by learning through smaller amounts and well-documented protocols.

What is the difference between DeFi lending and staking?

DeFi lending involves supplying assets to lending protocols so others can borrow them, with returns influenced by borrowing demand and market conditions. 

Staking usually involves locking assets to support network operations such as block validation. Rewards are tied to protocol-level incentives rather than lending activity.

Are DeFi loans taxable?

Tax treatment of DeFi lending and borrowing varies by jurisdiction. Events such as earning interest, liquidations or closing positions may have tax implications. 

Because rules differ widely, users may have to consult local tax guidance or professionals to understand how DeFi activity is treated in their region. Crypto.com doesn’t provide tax advice.

Important Information: This is informational content sponsored by Crypto.com and should not be considered as investment advice. Trading cryptocurrencies carries risks, including price volatility. Past performance may not indicate future results. There is no assurance of future profitability. Consider your risk appetite before trading cryptocurrencies.

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