Lending, and how it fails
Somebody borrows and pays interest. The mechanism is old and simple; the ways it breaks are specific and worth knowing before you lend.
Lending is the least exotic thing in crypto. You have an asset, somebody wants to borrow it, they pay for the privilege. Banks have done it for centuries.
What differs here is who stands behind the loan, and what happens when the borrower cannot repay.
Who is borrowing, and why
The demand is real and worth understanding, because it is what makes the interest legitimate.
Traders borrow to take leveraged positions. Holders borrow against their coins to get cash without selling, often for tax reasons. Market makers borrow inventory. And people who want to keep an asset while spending its value borrow rather than sell.
All of that produces genuine demand, which is why lending rates exist without anyone inventing them.
Two arrangements that share a name
A lending platform is a company. You deposit, they lend your coins to borrowers they select, and they pay you a share. Your relationship is with the company, not the borrower, and you generally cannot see who borrowed or on what terms.
A lending protocol is software. Deposits and loans sit in a contract with public rules, rates move automatically with supply and demand, and every position is visible on-chain. There is no company deciding who is creditworthy — the rules are the same for everyone.
Overcollateralised is the reason this works at all
On a protocol, a borrower must deposit more than they take — often 150 per cent or more. Nobody borrows on their reputation, because the software has no way to assess one. That is why the loans get repaid.
Liquidation, and why it protects you
If the collateral falls in value, the loan becomes under-secured. The protocol sells enough collateral to bring the position back in line, automatically, and usually pays a bounty to whoever triggers it.
From the borrower's side this is brutal and often happens at the worst price. From the lender's side it is the mechanism keeping the pool solvent, and it works — most of the time.
The specific ways it breaks
- The price moves faster than the liquidationA violent drop can leave positions under water before anyone can act. The shortfall becomes bad debt in the pool, shared by lenders.
- The price feed is wrongProtocols read prices from oracles. Manipulate a thin market feeding an oracle and you can borrow against collateral the protocol has mispriced. This has happened repeatedly.
- The contract has a flawAudits reduce this and do not eliminate it. A protocol holding hundreds of millions is a permanent, well-funded target.
- Everyone withdraws at onceIf most deposits are lent out, there is nothing to withdraw until borrowers repay. Rates spike to fix it, but for a while you simply cannot leave.
- The company was not doing what it saidThe failure mode unique to custodial platforms, and the one that has cost the most.
What 2022 actually demonstrated
Several large custodial lending platforms failed within months of each other, and their customers lost most of what they had deposited. It is worth being precise about why, because the wrong lesson is easy to draw.
They were not overcollateralised. They lent customer deposits to a small number of large borrowers, sometimes unsecured, and put deposits into strategies customers were never told about. When the borrowers failed, the deposits were gone — and customers discovered they were unsecured creditors in a bankruptcy rather than owners of anything.
The lending protocols running in the same period, with public rules and enforced collateral, mostly processed liquidations and kept working. That is not an argument that protocols are safe — they carry contract and oracle risk instead. It is an argument that "yield from lending" told you nothing, and the arrangement underneath told you everything.
"Your deposits are insured" usually means something narrower than it sounds
Read what is actually covered. Custody insurance against theft from a vault is not protection against the company becoming insolvent, and the second is what has actually happened.
What to ask before lending anything
Where does the interest come from — who borrowed and against what? What collateral secures the loan, and what happens if it falls? Can I withdraw right now, and what happens if everyone tries at once? And if this is a company: what exactly am I in the queue for if it fails?
A platform that answers all four clearly may still lose your money. One that cannot answer them will.