DeFi lending

In short

A friend of mine once lent his neighbor a ladder and got it back a week later, a little bent but still useful. DeFi lending is a bit like that, except nobody knows the neighbor and no one signs a form. You put crypto into a pool run by computer code, and others borrow from that pool and pay a fee. You earn a share of that fee, and you can lose money in ways a bank account never risks. Before you put in a single dollar, find out who can change the rules of the pool, what it pays you and why, and what happens when prices fall fast. Do your own reading, start with an amount you could watch vanish without losing sleep, and keep a record of every move for tax time. Nobody can promise you a result here, and that includes me.

The whole of it

What it is

I once watched an old pawnbroker take a watch across his counter, look it over, and hand a man cash worth about half its price. The man got money fast, the broker held the watch, and everybody understood the deal. DeFi lending works on the same bones. DeFi is short for decentralized finance, which means money tools run by software on a blockchain instead of by a company with a front desk. In a lending pool, people called suppliers deposit coins. People called borrowers take coins out, but first they lock up other coins as collateral, which is a pledge you forfeit if you do not pay back.

You have probably wondered why anyone would borrow this way. There are a few honest reasons. Someone may want cash but not want to sell coins they believe in. Someone may want to avoid selling because a sale can trigger a tax bill. Someone may simply want to use the loan to buy more. Each reason is the borrower's own business, and each one affects the risk you carry as a supplier, because your pool is only as healthy as its borrowers.

There is no loan officer and no credit check. The code does the job of the banker, and the code is public, so anyone can read it. That openness is a real strength. It does not make the code free of mistakes.

How it works

If you are holding a coin that just sits in your wallet, you may wonder if it could earn something. In a lending pool it can. You connect a wallet, which is the app that holds your keys, and you deposit. The pool often hands you a receipt token that shows your share. Borrowers pay interest, and the rate moves on its own. When many people want to borrow, rates climb. When few do, rates fall. No one phones you to say so.

Now picture the borrower. A woman named in my story below locks up coins worth more than she borrows. That gap is the cushion. If the price of her collateral drops and the cushion shrinks too far, the code sells her collateral on its own to repay the pool. This is called liquidation, and it happens fast, often with a penalty fee charged to the borrower. It protects you, the supplier, but only if the sale can happen at a fair price when everyone is rushing.

Price information comes from a feed called an oracle, which tells the code what each coin is worth right now. If the feed is wrong or gets tricked, the pool can make bad decisions in seconds. That is one of the places where things have broken before. You also pay small network fees every time you deposit, withdraw, or move funds, and those fees can eat a small balance whole.

The numbers, and where to find yours

You have probably seen a big percent on a screen and felt your pulse rise. Slow down, because that figure is a rate the pool shows today, and it can change by the hour. It is often called APY, the yearly return if the current rate held and earnings were added back in. It rarely holds. Some pools also pay extra reward tokens, and those carry their own price swings.

Three numbers are worth finding for any pool. The first is the supply rate, which is shown on the pool's own dashboard. The second is the collateral factor, the share of collateral value a person can borrow against, listed in the protocol's documentation. The third is the liquidation threshold, the point where a borrower's collateral gets sold. All of these are set by each protocol, not by law, so there is no official figure to quote. Read them on the protocol's own site and note the date you looked.

For tax, the official word comes from the Internal Revenue Service, which publishes guidance on digital assets on its website. The IRS says digital assets are treated as property for federal tax purposes. Its Form 1040 also carries a digital asset question near the top, and the exact wording changes, so read the current form and its instructions on irs.gov rather than trusting a screenshot, a forum post, or me. Interest you earn may count as income. The IRS has not spelled out every detail for receipt tokens, so check its digital asset pages for what it says today. A tax professional can speak to your situation. I cannot.

A worked example

A woman named Dolores kept 10 ether in her wallet, and she was tired of watching it sit still. Say ether trades at 2,000 dollars, a figure I picked only to make the sums easy. Her 10 ether is worth 10 times 2,000, which is 20,000 dollars.

She deposits the full 10 ether into a pool that shows a supply rate of 2 percent a year. If that rate held for a whole year, she would earn 2 percent of 20,000 dollars. That is 0.02 times 20,000, which is 400 dollars, or 0.2 ether at the same price. She also pays a network fee to deposit and another to withdraw. Say each costs 15 dollars. Two fees times 15 dollars is 30 dollars. Her earnings after those fees are 400 minus 30, or 370 dollars.

Now suppose a borrower named Walter locks up 10,000 dollars of another coin and borrows 6,000 dollars from the pool. His borrowed amount divided by his collateral is 6,000 divided by 10,000, or 60 percent. If the pool lets him borrow up to 75 percent, he has room, but not much. If his collateral falls 20 percent, it is worth 8,000 dollars. Now 6,000 divided by 8,000 is 75 percent, and he sits right at the line. A small further drop and the code sells his collateral.

Here is the part that matters to Dolores. If the price of ether itself falls 30 percent, her 20,000 dollars becomes 14,000. Thirty percent of 20,000 is 6,000, so she is down 6,000 dollars. Her 370 dollars of earnings covers only a sliver of that. Her earnings after fees would be 370 dollars, and 6,000 minus 370 leaves her still 5,630 dollars behind. The interest was real. So was the loss. She never lent dollars at all, because she lent a coin whose price moves.

Where it goes wrong

I have a neighbor who trusted a fence because it looked sturdy, and a storm showed him why you test a fence before you lean on it. Pools can fail in a few ways. The code can have a bug, and a clever attacker can drain funds before anyone reacts. Audits help, but an audit is one team's review at one moment, not a guarantee.

Prices can crash faster than liquidations can keep up, leaving the pool holding bad debt. When that happens, suppliers can share the loss. An oracle can report a wrong price. A pool run by a small group holding special keys can be changed overnight, so find out who holds those keys. Some pools freeze withdrawals when too much money leaves at once, which means you cannot always get out when you want to.

There is also the quiet risk of the number on the screen. High rates usually exist for a reason, and the reason is often risk. And there are tax records to keep, which people forget until April. Write down the date, the coin, the amount, and the price for every deposit, withdrawal, and reward. That small habit saves a lot of grief.

Questions to answer before you leave this page

If this pool failed tomorrow, could you live with the loss, and have you written down the amount you would be willing to lose? Do you know who can change the rules of the pool, and have you read what its audit reports actually say and when they were done? Can you explain, in your own words, where the interest comes from and what the borrowers pledge? Have you looked up the current rates and thresholds on the protocol's own site and noted the date? Do you understand the network fees on your balance, and would they swallow your earnings? Have you read the IRS guidance on digital assets at irs.gov, and do you have a way to record every transaction? And finally, if the price of your coin dropped by half while you slept, would you still be glad you made the move?