DEFI & WEB3
Lending and Borrowing Crypto Explained
Lending and borrowing have existed in traditional finance for centuries. In crypto, the same fundamental concept, putting idle capital to work by lending it to borrowers in exchange for interest, has been rebuilt from scratch using smart contracts, decentralised protocols, and transparent on-chain mechanics. The result is a lending market that operates 24 hours a day, seven days a week, requires no credit checks, and is accessible to anyone with a crypto wallet and an internet connection.
For investors, lending crypto provides a way to generate yield on assets held in a long-term portfolio. For borrowers, crypto lending provides access to liquidity without requiring the sale of appreciated assets, a structure with specific and significant tax advantages. For traders, it enables leveraged positions without going through a traditional exchange margin facility.
Understanding how it works, where the risks are, and what the tax treatment looks like is essential before allocating capital to any lending or borrowing activity.
How Crypto Lending Works
The core concept is straightforward. A lender deposits crypto assets into a lending protocol or platform. Those assets are made available for borrowers to use. Borrowers pay interest on their loans. That interest is distributed to lenders as yield.
What makes crypto lending different from traditional lending is how trust and security are established. Traditional lending relies on credit scores, income verification, legal contracts, and ultimately court systems to enforce repayment. Crypto lending, particularly in the DeFi context, replaces all of this with overcollateralisation and automated liquidation.
Overcollateralisation means that every borrower must deposit more value in collateral than they borrow. A borrower wanting to borrow $10,000 AUD worth of stablecoins might need to deposit $15,000 to $20,000 AUD worth of Ethereum or Bitcoin as collateral, depending on the platform’s collateralisation ratio. This eliminates the need for credit checks: the collateral is the security.
Automated liquidation is the mechanism that protects lenders if a borrower’s collateral value falls. If the value of the deposited collateral drops toward the value of the outstanding loan, the protocol automatically liquidates a portion of the collateral to repay the debt before the loan becomes undercollateralised. This process is executed by smart contracts without human intervention, operating continuously regardless of market hours.
The combination of overcollateralisation and automated liquidation means that lenders in well-designed protocols are protected from individual borrower default risk in a way that doesn’t require trust in the borrower. The risk shifts instead to smart contract security, oracle reliability, and market conditions that can move faster than liquidation mechanisms can respond.
Centralised Crypto Lending
Centralised crypto lending platforms operate similarly to traditional financial institutions: the platform custodies your assets, manages the lending book, and pays you a quoted interest rate. Examples include platforms operated by some centralised exchanges and dedicated lending platforms.
The appeal of centralised lending is simplicity. You deposit assets, you receive interest, and the platform manages everything else. No smart contract interactions, no gas fees, no wallet management beyond the initial deposit.
The risk of centralised lending is the same as the risk of keeping any crypto on an exchange: counterparty risk. As covered extensively in our risks of keeping crypto on an exchange resource, a centralised platform can be hacked, can become insolvent, can freeze withdrawals, or can be shut down by regulators. The collapse of centralised lending platforms including Celsius, BlockFi, and Voyager in 2022 resulted in billions of dollars in losses for users who believed their assets were being managed conservatively. In all three cases, users discovered that their deposits had been used in ways that created far more risk than was disclosed.
When using any centralised lending platform, the same due diligence applies as for any centralised exchange: verify regulatory compliance, understand where and how your assets are being deployed, check proof of reserves if available, and never deposit more than you can afford to lose to counterparty failure.
Decentralised Crypto Lending
Decentralised lending protocols operate through smart contracts on a blockchain, with no centralised intermediary controlling the assets. The most established protocols include Aave and Compound on Ethereum, and their equivalents on other networks.
In a decentralised lending protocol, the process works as follows. Lenders deposit assets into a lending pool smart contract and receive a corresponding receipt token representing their deposit and accrued interest. Borrowers deposit collateral, also into smart contracts, and can borrow up to a defined percentage of their collateral value. Interest rates adjust algorithmically based on the utilisation of each lending pool: when more of the pool is borrowed, rates rise to attract more lenders and discourage further borrowing, and vice versa.
The transparency of decentralised lending is one of its significant advantages. Every deposit, every loan, every liquidation, and the current state of every pool is visible on-chain in real time. There is no opacity about where the capital is deployed, what the utilisation rate is, or what the current interest rates are.
The risk profile is different from centralised lending but not necessarily lower. Smart contract vulnerabilities have resulted in significant losses from major protocols despite multiple audits. Oracle failures, where the price feeds that inform liquidation decisions provide incorrect data, have been exploited to manipulate liquidation thresholds and drain lending pools. And extreme market volatility can move prices faster than liquidation mechanisms can respond, creating bad debt in the protocol.
Why Borrow Against Crypto?
The borrowing side of crypto lending might seem counterintuitive at first. Why borrow against your crypto when you could simply sell it?
The answer for many investors is tax efficiency and maintained market exposure. When you sell a crypto asset, you trigger a disposal event and may owe capital gains tax on the gain. When you borrow against it, the asset remains in your ownership, you maintain your market exposure, and you receive liquidity without triggering a tax event.
For an investor holding a Bitcoin position with significant unrealised gains who wants to access liquidity for a major purchase without selling, borrowing stablecoins against their Bitcoin collateral preserves both the position and the deferred tax liability. The loan is repaid from income, from other liquidity sources, or by eventually selling a smaller portion of the position than would otherwise have been required.
Borrowing is also used for leverage: depositing one asset as collateral, borrowing another, and deploying the borrowed asset in a strategy that generates returns above the borrowing cost. This is a more sophisticated use case with additional risk dimensions that are covered in our leverage trading explained and understanding risk management resources.
Liquidation Risk: The Borrower's Primary Concern
The most significant risk for borrowers in crypto lending is liquidation: the automatic sale of collateral by the protocol when the collateral value falls toward the loan value.
Understanding how close to liquidation your position is at any time, and managing that distance actively, is the core risk management task for any crypto borrower. Protocols display a health factor or collateralisation ratio that indicates how far the position is from liquidation. Maintaining a comfortable buffer, significantly above the minimum collateralisation ratio, reduces the risk of liquidation during normal market volatility.
The danger increases sharply during rapid market moves. In a sudden 30% decline in Ethereum price, a position that appeared safely collateralised can approach the liquidation threshold in hours. If the borrower is not monitoring the position or cannot add collateral quickly, the protocol liquidates automatically, typically at a penalty that benefits liquidators as an incentive to maintain the protocol’s solvency.
Liquidation in a DeFi context is not a credit event in the traditional sense. There is no credit report impact, no legal action, no personal liability beyond the collateral deposited. But the collateral loss is real and permanent. Managing collateralisation ratios conservatively, monitoring positions during volatile market conditions, and having readily available assets to add collateral if needed are the practical risk management behaviours for borrowers.
Setting price alerts for collateral assets and maintaining a stablecoin reserve that can be quickly added as collateral in a declining market are simple and effective risk management practices.
Interest Rate Dynamics
Interest rates in DeFi lending markets are variable and change in real time based on the utilisation of each pool. Understanding how rates move and what drives them helps both lenders managing yield expectations and borrowers managing their cost of capital.
When utilisation is high, meaning most of the deposited assets are borrowed, rates rise. This higher rate serves two purposes: it rewards lenders for providing scarce liquidity, and it discourages further borrowing by making it more expensive. When utilisation falls, rates decline to encourage more borrowing and attract the capital into productive use.
For lenders, the variable rate means that the yield on a deposit is not guaranteed. A pool paying 8% APY today might pay 3% APY next month if significant new liquidity is deposited or if borrowing demand falls. Monitoring rates across protocols and across assets, and moving liquidity to where yields are most attractive relative to risk, is an active management task for yield-oriented lenders.
Some protocols offer fixed-rate lending products that remove the variable rate risk for lenders and borrowers who want predictability, at the cost of flexibility. These are less common but worth knowing about for investors who prioritise rate certainty.
Tax Treatment of Crypto Lending and Borrowing in Australia
The tax treatment of crypto lending activity has specific implications that Australian investors need to understand and plan for carefully.
Lending interest income. Interest earned from lending crypto assets is generally treated as ordinary income in Australia, assessable at the time of receipt at the AUD value of the interest received. This creates an ongoing tax obligation for active lenders, particularly in DeFi protocols where interest accrues continuously and is received as tokens that themselves may appreciate or depreciate in value after receipt.
Lending the asset itself. Depositing assets into a lending protocol in exchange for receipt tokens may or may not be a disposal event depending on the specific structure. If the receipt token is considered a different asset from the original, the deposit could trigger capital gains tax on the deposited asset. The ATO’s treatment of specific DeFi transactions is an evolving area and one where professional tax advice is particularly valuable.
Borrowing proceeds. In most structures, the proceeds of a crypto loan are not taxable income in the same way that a loan in traditional finance is not taxable. However, the specific structure of the borrowing, the asset borrowed, and how it is subsequently deployed all have tax implications.
Liquidation events. A liquidation where collateral is sold by the protocol is a disposal event subject to capital gains tax on the disposed collateral. The fact that the disposal was forced by the protocol rather than voluntary does not change the tax treatment.
Our resources on cryptocurrency tax Australia, tax implications of staking and yield farming in Australia, ATO crypto reporting, and how to report crypto losses for tax purposes in Australia provide the broader framework. Given the complexity of DeFi lending’s tax treatment, consultation with a qualified tax accountant who understands crypto is strongly recommended for anyone active in this space.
Evaluating Lending Protocols
Not all lending protocols carry the same risk profile. Several factors help distinguish more reliable protocols from more speculative ones.
Track record and TVL. Established protocols with years of continuous operation and significant total value locked have been battle-tested by real market conditions including periods of extreme volatility. A protocol that has operated through multiple market cycles without a significant exploit has demonstrated something that a newly launched protocol cannot.
Audit quality and history. Multiple independent audits from reputable security firms, publicly available audit reports, and a history of promptly addressing identified vulnerabilities are positive signals. The absence of credible auditing is a disqualifying red flag for any lending protocol regardless of its advertised yields.
Oracle security. Lending protocols depend on price oracles to determine collateral values and trigger liquidations. Protocols using decentralised oracle networks with manipulation-resistant designs are more secure than those using simpler price feed mechanisms that can be exploited.
Governance and upgrade mechanisms. Understanding who controls the protocol’s smart contracts, how upgrades are proposed and implemented, and whether there are meaningful time-locks and community oversight mechanisms on upgrades helps assess the risk of a malicious or erroneous protocol change affecting deposited assets.
Applying the how to identify promising crypto projects early framework alongside the security red flags in new crypto projects checklist to any lending protocol you’re considering is the appropriate research standard before any capital allocation.
Key Takeaways
Crypto lending allows investors to generate yield on held assets by making them available to borrowers, with overcollateralisation and automated liquidation replacing traditional credit mechanisms. Centralised lending introduces counterparty risk from platform insolvency or mismanagement, as dramatically demonstrated by the 2022 platform collapses. Decentralised lending through established DeFi protocols replaces counterparty risk with smart contract risk, oracle risk, and liquidation risk. Borrowing against crypto provides tax-efficient liquidity without triggering a disposal event, at the cost of liquidation risk if collateral values decline. Interest rates in DeFi are variable and demand active monitoring. Lending interest income is generally taxable as ordinary income in Australia, and liquidations are disposal events subject to capital gains tax. Protocol evaluation should prioritise track record, audit quality, oracle security, and governance structure.
Crypto lending is a genuinely useful tool for yield generation and tax-efficient liquidity. It is also a genuinely complex one with multiple risk dimensions that demand proper understanding before deployment.
For everyday investors who want to understand how lending and borrowing can fit into their crypto strategy safely and with genuine understanding of the mechanics, our Runite Tier Membership provides the education and frameworks to approach it properly. For serious investors who want personalised guidance on integrating lending and borrowing strategies within a professionally structured portfolio, our Black Emerald and Obsidian Tier Members receive direct specialist support covering every dimension of DeFi strategy.
Find out more at shepleycapital.com/membership.
WRITTEN & REVIEWED BY Chris Shepley
UPDATED: MARCH 2026
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