How does crypto lending work, and why must borrowers put up more than they borrow?

A pool, not a bank

ethereum.org says borrowing from decentralised lenders comes in two main kinds.⁵

• Peer-to-peer: a borrower borrows directly from one specific lender.⁵
• Pool-based: lenders put funds into a pool, and borrowers borrow from the pool.⁵

The biggest lending apps use pools. The Financial Stability Board (FSB) names Aave, Compound and MakerDAO as examples. In 2023 it said they pool assets from lenders, who earn interest, and rely on collateral rather than on judging whether borrowers can repay.¹

A pool is a set of smart contracts.^5,2 Aave's documentation describes what lenders get back. When you supply tokens, Aave creates aTokens for you, such as aUSDC, and their balance grows as borrowers pay interest.⁴

Borrowers lock up collateral and take a loan from the pool. Collateral means assets locked up as security for a loan. If the loan is not repaid, the lender gets the collateral automatically.^5,6

Why more collateral than loan?

A bank checks who you are before it lends. A June 2022 bulletin by economists at the Bank for International Settlements (BIS) explains that banks screen borrowers using hard facts, such as credit scores and income, and softer knowledge from dealing with them.³

DeFi lending can't do that. The borrowers' identities are hidden behind cryptographic signatures, so lenders can't see their credit scores or income.³ ethereum.org puts the same point as a benefit: you can borrow without credit checks or handing over private information.⁵

So collateral does the work. Aave's documentation says its loans are always over-collateralised: the collateral must be worth more than the loan.⁴ Crypto prices swing a lot, so the cushion is big. The BIS authors found that minimum collateral on major platforms was typically 120% to 150% of the loan.³

Collateral itself is old. The BIS authors note that the Temple of Apollo in ancient Rome reportedly made loans backed by property.³

Where lenders' interest comes from

Lenders earn because borrowers pay. Aave says lenders' yields are funded by borrowers' interest, minus the reserve factor.⁴ The reserve factor is the share of that interest that goes to the Aave treasury to help protect the protocol.⁶ Lesson 2 explains how the rate is set.

DeFi loans usually have no end date. The FSB says they have no fixed maturity, are sometimes called "perpetual", and can be repaid at any time.¹ Aave says loans stay open as long as there is enough collateral.⁴

Why borrow at all?

• To get cash without selling. ethereum.org gives the example of using ether as collateral for a stablecoin loan.⁵ Module 22 explains stablecoins.
• To make bigger bets. The BIS authors say borrowers use DeFi lending to gain leveraged exposure to crypto, meaning bets bigger than their own money, or to adjust their holdings.³
• Not, so far, for the real economy. DeFi loans are paid out in crypto and secured by crypto, so in 2022 the BIS authors said they did not finance real-world business.³

Who gets left out

The BIS authors point out a cost. To borrow, you must already own more than you want to borrow. So DeFi lending can't help people or small firms that have few assets.³

A special case: flash loans

Aave's glossary describes a flash loan as a loan with no collateral that must be borrowed and repaid within one transaction.⁶ The FSB explains that the steps of a flash loan are settled all together or not at all, which it calls "atomic settlement".¹ It says flash loans have been used mostly for arbitrage and trading, and also by attackers to manipulate prices.¹ Module 15 covers that kind of attack.