DeFi lending works by pooling deposits in a smart contract that lends them out against collateral posted by borrowers. Loans are overcollateralized, so the borrower always locks up more value than they take out. Interest rates move automatically with how much of the pool is borrowed, and positions that fall below a collateral threshold are sold off by third parties.
Credit assessment appears nowhere in that description. That absence is the single largest structural difference from bank lending, and it explains the rest of the design: the collateral requirement, the automatic rate, and the outsourcing of enforcement to whoever spots a weak position first. Lending sits alongside tokenized treasuries and trading strategies as one of the main onchain yield sources.
How does supplying and borrowing work?
A lender deposits an asset into a market and earns interest; a borrower posts a different asset as collateral and draws the first one against it. In a typical isolated market design, the market pairs one collateral asset with one loan asset and is defined by five parameters fixed at deployment: the collateral token, the loan token, the maximum borrowing ratio, the price oracle, and the interest rate model.
Two details surprise people arriving from traditional credit. The borrower's collateral is not itself lent out; it sits in the contract securing the position. A lender's ability to withdraw then depends on there being unborrowed capital in the pool at that moment, since supplied assets can be withdrawn only "provided there is enough liquidity in the market", so nothing about supplying is term-locked and nothing about it is guaranteed to be available on demand.
Why are DeFi loans overcollateralized?
There is no recourse against the borrower. Positions are pseudonymous, there is no underwriting, no covenant package, no court to sue in and no balance sheet to look at, so the only thing standing between a lender and a loss is the collateral already sitting in the contract, and it has to be worth more than the loan.
The ratio is set per market. A maximum borrowing ratio of 80% means $100 of collateral supports $80 of borrowing. The excess is a buffer against the collateral falling in price faster than the position can be closed, and it is why volatile collateral carries a lower ratio than stable collateral: the buffer has to survive the price move, and the plausible size of that move differs by asset.
Overcollateralization caps what the market can do. It makes lending against a business, a receivable or a credit rating impossible here, so the borrower base is dominated by traders financing positions, holders unwilling to sell and leverage strategies, and lender yield comes from that demand and moves with it.
How are interest rates set?
By utilization, meaning the share of supplied capital that is currently borrowed. The rate is a function of that number rather than something a committee sets or a counterparty negotiates.
One widely used model targets utilization near 90% and adjusts in two ways. There is an immediate curve response, so that if utilization jumps to 100% the rate rises sharply at once, and a slower shift of the whole curve when utilization stays away from target: upward while utilization runs above target, to encourage repayment, and downward while it runs below, to encourage borrowing. Lender yield is derived from the borrow rate rather than set separately, and in that model supply APY equals the borrow APY multiplied by utilization, less any protocol fee.
A lender therefore earns nothing on the unborrowed portion of their deposit. A market at 40% utilization pays its lenders roughly 40% of the headline borrow rate.
When a borrower stops being safe
The trigger is arithmetic. When a position's loan-to-value passes the market's liquidation threshold, a third party can repay part or all of the debt, take the collateral at a discount and close the position, and the discount is the incentive that makes anyone bother.
Liquidation protects the lender, and it is also the point at which the lender is most exposed. If the collateral price gaps down faster than liquidators can act, or the price feed misreports, the seized collateral may not cover the debt. The shortfall is bad debt. It lands on the suppliers of that market, and designs differ in how honestly they show it: some realize the loss immediately and share it proportionally between all lenders, while others leave the unpaid debt accruing on the books indefinitely. The full mechanism is covered in what is a liquidation.
What a lender is actually exposed to
Four things, none of them the borrower's creditworthiness: the collateral asset and how fast it can fall, the oracle that every solvency check runs against, the contract code holding the funds, and liquidity, since a supplier can only withdraw what is not currently borrowed.
For an allocator, the practical comparison is against the other place a cash-like balance can sit: a tokenized short-duration instrument. Those instruments trade the utilization risk above for issuer, duration and settlement-timing risk, and they do not pay a rate that swings with borrower demand, so the choice between the two is mostly a decision about what kind of risk a cash balance should carry. Neither route removes risk. Each relocates it.
FAQ
How does DeFi lending work in one paragraph?
Lenders deposit an asset into a market contract. Borrowers lock a different asset as collateral and draw against it, up to a fixed ratio of the collateral's value. Interest accrues automatically at a rate driven by how much of the pool is borrowed. If a borrower's collateral cover falls too far, a third party liquidates the position.
Why do borrowers post more collateral than they borrow?
Because there is no credit assessment and no recourse. The lender cannot pursue a pseudonymous borrower, so the collateral is the entire protection, and the excess is a buffer that gives liquidators time to close the position before the collateral is worth less than the debt.
Who sets the interest rate?
An algorithm, using utilization. Rates rise as borrowing consumes more of the pool and fall as it empties, and lender yield is the borrow rate scaled by utilization minus fees. Nobody negotiates a rate. Rates can move materially within a single day.
Can a lender lose money?
Yes. If liquidation fails to recover the full debt, the shortfall becomes bad debt carried by the market's suppliers. Contract failure, a mispriced oracle and a collateral asset losing its peg or its liquidity are the other main paths to loss.