Lesson 6: Lending and Borrowing

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Lesson 6: Lending and Borrowing

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Core concept: DeFi lending protocols let you earn interest by lending crypto or borrow crypto by posting collateral—no credit checks, no applications, instant execution.

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Pawn Shop with Code

Inline Analogy

Think about how a pawn shop works:

• You bring valuable items (collateral)

• They give you cash (loan)

• You pay interest over time

• Pay back the loan + interest, get your items back

• Don't pay back? They keep your items

DeFi lending works similarly:

• You deposit crypto (collateral)

• Smart contract lets you borrow other crypto

• You pay interest over time

• Repay loan + interest, get collateral back

• If collateral value drops too much? Automatic liquidation

The "pawn shop" is a smart contract. No negotiation. No credit check. Just math.

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How DeFi Lending Works

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For Lenders (Depositors):

1. You deposit crypto into a lending protocol

2. Your deposit joins a lending pool

3. Borrowers pay interest on what they borrow

4. You earn a portion of that interest

5. Withdraw your deposit + earned interest anytime

For Borrowers:

1. You deposit collateral (usually more than you borrow)

2. Protocol lets you borrow up to a certain percentage of collateral value

3. You pay interest on borrowed amount

4. Repay anytime to get collateral back

5. If collateral value drops, you might get liquidated

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The Overcollateralization Requirement

Unlike traditional loans (where you might borrow $250,000 for a $300,000 house), DeFi requires more collateral than what you borrow:

Example:

• You want to borrow $1,000 USDC

• Protocol requires 150% collateralization

• You must deposit $1,500 worth of ETH

• If ETH price drops and your collateral falls to $1,200, liquidation may occur

Why so much collateral? Because:

• No credit checks to assess risk

• No legal system to chase you for repayment

• Smart contracts can't send debt collectors

Overcollateralization is how DeFi manages risk without knowing who you are.

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Why Would You Borrow?

If you need to deposit more than you borrow, why borrow at all?

Keep asset exposure: You want to hold ETH but need cash. Instead of selling, you borrow against it. If ETH goes up, you still benefit.

Tax efficiency: In some jurisdictions, borrowing against assets isn't a taxable event, but selling is.

Leverage: Advanced users borrow to increase their position. (High risk—not for beginners!)

Access different assets: Your wealth is in ETH but you need stablecoins for something.

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Popular Lending Protocols

Aave: Multi-chain lending protocol. Supports many assets. Variable and stable rates.

Compound: Pioneer in DeFi lending. Primarily on Ethereum.

MakerDAO: Create DAI stablecoin by depositing collateral. Unique model.

Morpho: Peer-to-peer layer on top of Aave/Compound for better rates.

Each has different rates, supported assets, and risk profiles.

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Risks of DeFi Lending

Liquidation risk: If collateral value drops, you can lose it. Market volatility is real.

Smart contract risk: Bugs in lending protocol code could result in lost funds.

Interest rate volatility: Rates can change rapidly based on supply/demand.

Oracle risk: Protocols rely on price feeds (oracles). Faulty prices can cause improper liquidations.

Opportunity cost: Funds locked as collateral can't be used for other purposes.

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Summary

Key Takeaways

• DeFi lending lets you earn interest by depositing crypto into lending pools

• Borrowing requires overcollateralization—deposit more value than you borrow

• No credit checks or applications—smart contracts enforce rules automatically

• Liquidation is automatic if collateral value drops below threshold

• Use cases include maintaining exposure, tax efficiency, and accessing different assets

• Significant risks exist—liquidation, smart contract bugs, and rate volatility