Decentralised finance lending promises something traditional banks rarely offer: earn interest on your crypto, or borrow against it, without a bank in the middle, often at rates that look far better than savings accounts. But those yields come with risks that are less visible than a bank's fine print, including liquidation, smart contract bugs, oracle failures and stablecoin depegs. Understanding how DeFi lending actually works, and where it can break, is essential before you deposit funds, because in DeFi there is no customer service desk to reverse a liquidation or recover a hacked deposit.

In a typical DeFi lending protocol, you deposit crypto as collateral, and the protocol lets you borrow another asset up to a certain percentage of that collateral, known as the loan-to-value ratio. Lenders earn interest from borrowers, and the protocol is governed by smart contracts, code that automatically enforces the rules, rather than by a bank manager. For example, depositing Ethereum as collateral might let you borrow stablecoins worth 70 percent of its value, and as long as the collateral value stays above a threshold, the loan remains healthy. The system works well when prices are stable, but it is designed to liquidate automatically when collateral falls, which is where the main risk lies.

Liquidation is the protocol's safety mechanism: if your collateral value falls below a required health factor, usually because the price of your collateral dropped or the price of your borrowed asset rose, the protocol allows liquidators to repay part of your loan and take your collateral, plus a penalty, to protect lenders. Liquidations can happen very quickly in a market crash, because prices move fast and many loans liquidate at once, creating further selling pressure. To manage this risk, borrow far below the maximum, monitor your health factor regularly, keep extra collateral ready, and avoid borrowing volatile assets against volatile collateral. A loan that looks safe in a calm market can become unsafe within hours in a crash, so a conservative loan-to-value ratio is the single best protection.

Beyond liquidation, DeFi lending carries smart contract risk: a bug in the protocol's code, or in a connected protocol it interacts with, can be exploited by hackers to drain deposits, and audits reduce but do not eliminate this risk. Oracle risk is related: protocols rely on price feeds, or oracles, to value collateral, and if an oracle reports a wrong price, due to manipulation or failure, liquidations can trigger incorrectly. Protocol governance risk also matters: token holders can vote to change interest rates, collateral factors or supported assets, sometimes in ways that affect existing borrowers. Using well-established protocols with long track records, multiple audits and bug bounties reduces, but never removes, these risks, which is why diversification across protocols is wise.

If you borrow or lend stablecoins, you also carry stablecoin risk: a stablecoin that depegs, losing its peg to the dollar, can change the value of your loan or deposit overnight, and can trigger liquidations in unexpected ways. Interest rates in DeFi are variable, not fixed, so borrowing costs can spike during high demand, and lending yields can fall just as quickly, making long-term planning harder. Liquidity risk matters too: in a crisis, you may be unable to withdraw or repay quickly because the protocol's assets are lent out, or because gas fees spike and your transaction is delayed. Always check the stablecoin's backing and history, the protocol's utilisation rate, and whether rates are variable before committing funds.

Manage DeFi lending risk with simple rules: only deposit funds you can afford to lose, start with a small test deposit and a small loan, keep your loan-to-value ratio well below the maximum, and check your health factor at least daily during volatile markets. Use hardware wallets and revoke unnecessary token approvals regularly, keep a record of every deposit and loan for tax purposes, and have a plan for a crash, including extra collateral or stablecoins ready to repay. Most importantly, do not chase the highest yield: a protocol offering double the market rate is usually taking double the risk somewhere, whether in collateral quality, leverage or unaudited code, and that risk eventually lands on depositors.

This is educational content, not financial advice, and you should never share a seed phrase with anyone, for any reason.