8.2 Lending Protocols

Lending and borrowing is one of the foundational activities in DeFi. Here's how they work, what major protocols are, and what to watch out for.

How DeFi Lending Works

• Users who hold crypto assets (like ETH or USDC) can lend / supply them into liquidity pools on lending protocols (like Aave or Compound). These pools are shared pools of funds available for others to borrow from.
• Earning Interest: By supplying assets to these pools, users become liquidity providers and earn interest, which comes from borrowers who pay to use the funds.
• Borrowing with Collateral: Users who want to borrow from the pool must deposit collateral—typically in another crypto token—to secure the loan. Because there is no centralized structure doing credit checks or legal claims, the collateral is usually over‑collateralised (i.e. worth more than the loan) to protect lenders from default or collateral depreciation.
• Dynamic Interest Rates: Interest rates adjust automatically based on supply and demand in a given “market” (i.e. for that token) — if many want to borrow a token but few have supplied it, borrowing cost rises; if many supply and few borrow, rates drop.
• Liquidation Risk: If the value of the collateral falls below a certain threshold (due to market price changes), smart contracts will automatically liquidate it—selling or using it to repay the loan. This helps ensure lenders are repaid and the pool stays solvent.

Examples of Lending Protocols

Here are some protocol types / examples:

• Aave: One of the most widely used DeFi lending platforms. Allows supplying of assets, borrowing, and also has features like variable vs stable borrowing rates.
• Compound: Similar in many respects; users supply tokens, receive interest‑bearing tokens (cTokens) representing claims on supplied funds. Borrowing and lending rates adjust automatically based on supply and demand (called utilization rate).
• MakerDAO: Rather than “lending” in the same way, Maker allows locking up collateral (e.g. ETH) in a Collateralized Debt Position (CDP). This allows them to mint and borrow DAI (a stablecoin)—essentially borrowing against their crypto without selling it.

Key Features and Variants

• Flash Loans: These are instant, uncollateralized loans which must be repaid in the same blockchain transaction (i.e. the same block) in which they are taken. If the loan isn’t fully repaid in that single transaction, the entire transaction fails—this is called an atomic transaction. Flash loans are used mostly by developers and advanced users for things like arbitrage, collateral swapping, or debt restructuring—not typically for beginners.
• Stable vs Variable Borrowing Rates: Some protocols offer options for borrowers to pick a more stable rate to protect against rate spikes. This flexibility helps borrowers manage risk based on their financial strategy.
• Governance / Token Incentives: Most lending protocols have their own governance tokens (AAVE, COMP, etc.) which allow holders to vote on changes, and often distribute rewards to users to encourage supplying and borrowing.

Risks in Lending and Borrowing

Even though DeFi lending offers powerful tools, it also comes with important risks to understand:

Collateral Volatility

• The value of crypto used as collateral can drop quickly due to market swings.
• If it falls below a safe threshold, your position can be automatically liquidated—meaning your collateral is sold to repay the loan.

Interest Rate Risk

• Most borrowing rates in DeFi are variable and change based on market conditions.
• If demand spikes, rates can rise sharply, making loans more expensive than expected.

Smart Contract Risk

• DeFi protocols rely on code to run. If that code has bugs or is hacked, funds can be stolen or lost.
• Even well-known protocols can be vulnerable if security isn't strong or updated.

Liquidity Risk

• If not enough funds are available in the protocol’s liquidity pools, it can be difficult to withdraw or close positions—especially during periods of market stress.

Concentration Risk

• Risks increase when:
  • A large number of users rely on the same type of collateral (e.g. ETH or a single stablecoin).
  • A few large users supply most of the funds—if they withdraw or get liquidated, it can affect the entire system.
• Even the IMF has raised concerns about these systemic risks in the DeFi lending space.

Conclusion

Lending protocols are a foundational part of the DeFi ecosystem, enabling new ways for people to put their crypto to work or access liquidity without traditional gatekeepers. They introduce a more programmable and open-ended approach to borrowing and lending—but with that flexibility comes complexity and risk. As we move forward, understanding these tools at a deeper level will help you use them more confidently and recognize where innovation is heading next in decentralized finance.