Crypto lending is the practice of lending digital assets to borrowers in exchange for interest, or of borrowing cash or stablecoins against crypto held as collateral. In DeFi, it runs on lending protocols built from smart contracts, where pooled deposits, interest rates and liquidations are handled by code rather than by a loan officer.
Crypto lending also exists in a centralized form, in which a company takes custody of customer assets and lends them on. Both forms share the same economics, but they differ sharply in who holds the assets, who sets the rules and what happens when things go wrong.
How DeFi lending protocols work
A typical DeFi lending protocol, such as Aave or Compound, runs pooled lending markets. Lenders deposit an asset into a pool and receive a receipt token that grows in value or balance as interest accrues. Borrowers deposit collateral in another asset and draw a loan from the pool, paying a variable or sometimes stable rate.
Because borrowers are anonymous and there is no credit check, almost all DeFi loans are overcollateralized: the collateral must be worth more than the loan. A price oracle feeds market prices into the contracts so the protocol can measure each position continuously and liquidate it automatically when collateral value falls too far.
Interest rates are set by a utilization curve. When only a small share of a pool is borrowed, rates are low; as utilization rises toward a target, often around 80 to 90 percent, rates climb steeply to attract new deposits and discourage further borrowing, which keeps enough liquidity for withdrawals.
Key parameters of a crypto loan
Every collateral asset in a lending market has risk parameters set by governance. The table summarizes the most important ones and their typical ranges, which vary by asset volatility and liquidity.
| Parameter | Meaning | Typical range |
|---|---|---|
| Loan-to-value (LTV) | Maximum borrowing power per unit of collateral | About 50 to 80 percent for major assets |
| Liquidation threshold | Point at which a position becomes liquidatable | A few points above the maximum LTV |
| Health factor | Collateral value at threshold divided by debt | Liquidation below 1.0 |
| Liquidation bonus | Discount paid to liquidators on seized collateral | About 5 to 15 percent |
| Reserve factor | Share of interest kept by the protocol | About 10 to 25 percent |
| Supply and borrow caps | Limits on total exposure to one asset | Set per market by governance |
The health factor is the number borrowers watch most closely. A value of 2.0 means the collateral could fall by roughly half before liquidation; a value of 1.1 leaves almost no buffer in a volatile market.
Centralized and decentralized crypto lending
The difference between the two models is primarily about custody and transparency, not about the interest rates on offer.
| Aspect | Centralized platform | DeFi protocol |
|---|---|---|
| Custody | Platform holds customer assets | User keeps control via a wallet |
| Visibility of loans | Opaque, internal ledger | Public, on-chain positions |
| Collateral rules | Set and changed by the company | Encoded in contracts and governance |
| Failure mode | Insolvency, frozen withdrawals | Smart contract bugs, oracle errors |
| Identity checks | KYC required | Usually none at protocol level |
In 2022, several large centralized lenders froze withdrawals and entered bankruptcy after lending customer assets to risky counterparties. Their customers became unsecured creditors. DeFi protocols largely kept operating through the same crash because liquidations were automatic and positions were visible, although they carry their own technical risks.
Liquidations and related DeFi mechanisms
When a health factor falls below 1.0, liquidators repay part of the debt and receive collateral at a discount. This is profitable work for bots, and it is what keeps the protocol solvent. A single liquidation can typically close up to half of the debt, depending on the protocol and the size of the shortfall.
Crypto lending is closely linked to neighboring DeFi tools. Flash loans are uncollateralized loans that must be repaid within one transaction, and liquidators often use them to repay debt without capital of their own. Yield farming strategies frequently borrow from lending markets to amplify returns, which increases leverage across the system.
| Activity | Collateral | Main return or use |
|---|---|---|
| Crypto lending | Overcollateralized deposits | Interest from borrowers |
| Flash loan | None, repaid in the same transaction | Arbitrage, liquidations, refinancing |
| Liquidity provision | Pairs of tokens in a pool | Trading fees, with impermanent loss |
| Yield farming | Varies by strategy | Incentive tokens and stacked yields |
Risks and common mistakes
The advertised interest rate is only part of the picture. Lenders and borrowers face several layers of risk at once, and the highest yields usually signal the highest risk.
- Liquidation risk: a sharp price drop can wipe out the collateral buffer within minutes.
- Smart contract risk: bugs or upgrades can expose pooled funds to theft.
- Oracle risk: manipulated or stale prices can trigger unfair liquidations or bad debt.
- Liquidity risk: at full utilization, lenders may be unable to withdraw until loans are repaid.
- Counterparty risk on centralized platforms, where deposits are not protected like bank deposits.
A frequent mistake is borrowing close to the maximum LTV and leaving no margin for volatility. Another is treating a stablecoin as a risk-free collateral asset, which ignores the possibility of a depeg.
In plain words
Crypto lending works much like a pawn shop run by software. You leave something valuable as a deposit and borrow less than it is worth. If the value of your deposit drops too far, the shop sells it to cover the loan.
Lenders put their coins into a shared pool and earn interest from borrowers. The main lesson is simple: the higher the promised return, the more can go wrong.
A real-world example
An investor holds 10 ETH and expects its price to rise over the coming year but needs 8,000 dollars for a business expense. Instead of selling, the investor deposits the ETH into a DeFi lending market where it is worth 30,000 dollars and borrows 8,000 in a stablecoin. With a liquidation threshold of 82.5 percent, the starting health factor is about 3.1.
Two months later, ETH falls by 40 percent and the health factor drops to roughly 1.9. The investor receives an alert, repays 2,000 dollars to restore a wider buffer and avoids liquidation. The outcome is access to cash without a taxable sale in many jurisdictions, at the cost of interest payments and the need to monitor the position actively.