Borrowing (DeFi)

How it works

The mechanics on a typical DeFi lending protocol like Aave or Compound:

1. Deposit a supported asset (ETH, WBTC, stablecoins) into the protocol as collateral.
2. The protocol assigns a "loan-to-value" (LTV) ratio — the maximum you can borrow against that collateral. Volatile assets get lower LTVs (50-75%); stablecoins get higher ones (75-90%).
3. Borrow another asset up to that LTV.
4. Pay variable interest while the loan is open.
5. Repay the loan (plus accrued interest) to unlock your collateral.

If your collateral value drops or your debt grows enough to push you past a "liquidation threshold" (slightly higher than the LTV cap), liquidator bots step in: they repay part of your debt and seize a proportional chunk of your collateral plus a liquidation penalty. Liquidations happen automatically — there's no grace period and no manual review.

Why people borrow against crypto

Several common motivations:

• Stay long, get cash. Borrowing stablecoins against crypto collateral lets you use the dollar value of your holdings without selling — avoiding a capital gains tax event and keeping the upside if the collateral appreciates.
• Leverage. Borrow stablecoins, swap to more crypto, deposit again, borrow more — repeat. Each cycle increases exposure. This is the basic recipe for a leveraged long position via lending markets.
• Funding short positions. Borrow ETH, sell it, hope to buy back cheaper later, repay the loan in ETH, pocket the difference.
• Yield strategies. Borrow at one rate, deploy elsewhere at a higher rate. Works only when the spread persists net of risk.

Risks specific to DeFi borrowing

The mechanism is honest about its risks but they're often underestimated:

• Liquidation cascades. Falling prices trigger liquidations, which cause forced selling, which pushes prices lower, which triggers more liquidations. May 2021's market drawdown and the November 2022 FTX collapse both produced liquidation cascades that wiped out highly-levered borrowers.
• Oracle issues. Collateral value is read from price oracles (typically Chainlink). A stale or manipulated oracle can trigger inappropriate liquidations or allow under-collateralized borrowing.
• Interest-rate volatility. Borrowing rates can spike sharply when pool utilization gets high. A 5% borrow rate today can be 50% next week.
• Smart-contract risk. The whole position is at the mercy of the protocol's code. Even audited protocols have been exploited.

CeFi vs. DeFi borrowing

The same economic transaction exists in centralized form: services like Coinbase, Ledn, and historically Celsius, BlockFi, and Genesis offered crypto-collateralized loans run by a custodian. The 2022 bear market wiped out most of that industry — Celsius, BlockFi, Voyager, Genesis all failed, in some cases losing user deposits entirely. Surviving CeFi lenders have tightened risk management, but the structural counterparty risk remains.

DeFi versions are more transparent (anyone can see the protocol's positions) and don't have a central party that can fail with your funds, but require active management and exposure to smart-contract risk.

Compared to traditional lending

The structural difference between DeFi borrowing and a traditional bank loan: no credit check, no income verification, no relationship management — but full collateralization required from day one. Traditional finance extends credit on the basis of expected income and reputation; DeFi extends credit only against locked assets. This is why DeFi lending markets are useful for people who already have crypto wealth and is much less useful for people who don't.