A bank can evaluate salary, identity, and repayment history before making a loan. A public blockchain usually does not know those facts. DeFi lending therefore relies on a different protection: borrowers commonly lock collateral worth more than the amount they borrow.
Lenders deposit assets into a smart-contract pool. Borrowers draw from that shared pool after supplying acceptable collateral. The protocol records deposits, debts, interest, and collateral ratios on-chain, while its rules apply equally to any wallet that can submit a valid transaction.
Imagine depositing ether worth $1,500 and borrowing $800 in stablecoins. You still benefit if ether rises, and you gain spendable stablecoins without selling it. But if ether falls, the safety margin shrinks. Borrowing the maximum allowed amount leaves very little room for market movement.
Interest rates are often driven by utilisation. When most of a pool is available, borrowing can be cheap. As more assets are borrowed and liquidity becomes scarce, rates rise to encourage repayment and attract new deposits. The exact curve is code defined by each protocol.
This system makes loans fast and transparent, but it is not unsecured credit. Overcollateralisation protects lenders precisely because the protocol cannot chase an anonymous borrower later. It also means borrowers already need valuable assets, so DeFi lending does not solve every financial access problem.
Depositors face risks too: smart-contract bugs, bad collateral, oracle failures, governance changes, and periods when withdrawals are constrained because too much of the pool is borrowed. A displayed supply rate can change rapidly and is not the same as a guaranteed bank deposit.
If collateral can fall below the safe level, the protocol needs a way to act before the loan becomes undercollateralised. Tomorrow we will examine liquidation—the automatic process that protects the pool but can be painful for borrowers.