DeFi lending and borrowing protocols are the largest category of DeFi by total value locked - and the category most likely to be encountered by someone wanting to put their crypto to work generating yield. Understanding how these protocols function - particularly the mechanics of collateralisation and liquidation - is essential before depositing any assets. The yield offered by DeFi protocols is not free money. It is compensation for risk - liquidity risk, smart contract risk, and market risk that traditional financial instruments do not carry. This lesson explains the mechanics and the risks with equal emphasis.
How DeFi Lending Works
DeFi lending protocols - Aave and Compound are the most established - operate as automated money markets. Lenders deposit assets into a protocol's liquidity pool and earn interest. Borrowers take loans from the pool by posting collateral worth more than the amount borrowed. The interest rate adjusts algorithmically based on supply and demand - when the pool has high utilisation (most deposits are lent out), rates rise to attract more lenders. When utilisation is low, rates fall.
Alice deposits 10 ETH into Aave:
• Alice receives aETH tokens representing her deposit plus interest.
• Interest accrues in real time - her aETH balance grows continuously.
Bob wants to borrow USDC:
• Bob deposits 5 ETH as collateral. Collateral factor: 80% (borrow limit).
• At ETH $3,000, collateral = $15,000. Bob can borrow up to $12,000 USDC.
• Bob borrows $8,000 USDC. Interest accrues on Bob's debt.
Collateralisation and Liquidation
The Over-Collateralisation requirement exists because DeFi has no credit system. Traditional lenders assess your ability to repay based on income, credit history, and identity. DeFi protocols cannot assess any of this - they only know what is in your wallet. Requiring collateral worth more than the loan protects lenders if the borrower simply walks away.
When collateral value falls - because the price of the collateral asset drops - the loan-to-value (LTV) ratio worsens. When it reaches the protocol's liquidation threshold, Liquidation is triggered automatically: liquidators (bots or users) can repay a portion of the debt and claim the collateral at a discount. This protects protocol solvency but can result in borrowers losing a significant portion of their collateral.
• Bob borrowed $8,000 USDC against 5 ETH collateral at $3,000/ETH ($15,000). Current LTV: 53%. Liquidation threshold: 85%.
• ETH price falls to $1,900. Collateral value: $9,500. LTV: $8,000 / $9,500 = 84.2%. Approaching threshold - critical risk.
• ETH falls to $1,850. LTV: $8,000 / $9,250 = 86.5%. Exceeds 85%.
• Liquidation Triggered: A liquidator repays Bob's USDC debt and takes Bob's ETH at a 5% discount. Bob loses collateral but keeps the borrowed $8,000 USDC. Significant net loss.
Yield Sources in DeFi
Not all DeFi yield comes from the same source - and the source matters enormously for assessing sustainability and risk. Standard yield rate figures are quoted as APY (Annual Percentage Yield), which includes compounding.
• Lending interest: Paid by borrowers. Highly sustainable as it is driven by organic credit demand.
• Liquidity fees: Paid by traders executing swaps on DEXs. Sustainable as long as trading volume persists.
• Liquidity mining: Paid in newly minted governance tokens to bootstrap liquidity. Highly dilutive and unsustainable in the long term.
• Staking rewards: Paid by network inflation or fee distributions (e.g., Ethereum staking).
Liquidity Provision and Impermanent Loss
Providing liquidity to a DEX pool earns trading fees - but carries the risk of Impermanent Loss. When you deposit two tokens into an AMM pool (e.g., ETH and USDC), the pool automatically rebalances as prices change. If ETH's price rises significantly, the pool sells ETH and buys USDC - leaving you with less ETH and more USDC than you started with.
The loss is "impermanent" because if the price ratio returns to its original level, the loss disappears. But if you withdraw when the prices have diverged, you realise the loss. If you performed Liquidity Mining during this time, the token rewards may offset this loss, but the risk remains high.
Realistic Yield Expectations
DeFi yield expectations must be calibrated honestly. During bull markets and periods of high token incentives, APYs of 50-1000% have been available - but these invariably reflected unsustainable token inflation rather than genuine economic yield, and collapsed as incentive programmes ended and token prices fell.
Sustainable DeFi yield - yield driven by genuine borrower demand and trading fees without token inflation - typically ranges from 2-15% APY depending on the protocol, the asset, and market conditions. Stablecoin lending during high-demand periods may reach 5-10%. ETH staking currently produces approximately 3-5%. Anything significantly above these levels represents either elevated risk or temporary incentive programmes that will not last.
The most important DeFi yield principle: yield that cannot be explained has a source you are not being told about. If a protocol offers 300% APY on stablecoins with no obvious source of that yield - the yield is coming from somewhere. Almost always, that somewhere is newly minted governance tokens, unsustainable Ponzi mechanics, or undisclosed leverage. Understand the source of every yield before depositing.