Decentralized lending protocols use smart contracts to pool supplied tokens and make them available to borrowers. Interest rates can change automatically as supply and borrowing demand change.
Supplying and borrowing
A supplier deposits tokens into protocol contracts and may receive interest funded by borrowers. A borrower typically posts more collateral value than the amount borrowed, because crypto prices can move quickly.
On Aave, for example, supplied assets enter liquidity pools and interest rates respond to utilization and governance-set parameters. Each protocol has its own assets, oracles, limits, and smart contracts.
Borrowing usually requires collateral first
Many DeFi loans are overcollateralized: the deposited collateral is worth more than the borrowed amount. This structure lets smart contracts manage credit risk without a traditional identity check.
Liquidation and contract risk
If collateral falls below a protocol’s required threshold, some of it can be sold to repay the debt. This can happen automatically and quickly, even if the owner expects the price to recover later.
Other risks include faulty price feeds, smart-contract bugs, governance changes, stablecoin depegging, and network congestion. A displayed yield is variable and does not describe the full risk of the position.
Liquidation is an automated risk control
If collateral value falls too far relative to debt, the protocol can sell collateral. Users should understand the threshold, penalties, oracle design, and rate changes before borrowing.
Sources
Educational information, not investment advice.