12 min read
DeFi vs centralized crypto loans: how smart-contract lending works, wrapped Bitcoin and the added risks
How DeFi loans work: collateral, utilization-based rates, health factor and liquidation, WBTC vs cbBTC vs tBTC, FDIC and SIPC gaps, and how they compare with centralized lenders.
A DeFi loan lets a wallet deposit crypto into a smart contract and borrow another crypto asset against it, usually without a traditional credit application. The loan is over-collateralized (opens in a new tab), which means the deposited collateral must be worth more than the debt. Interest follows the protocol's rate model and often moves as the share of a pool that is borrowed changes. If collateral falls in value, debt grows, or an oracle (the price feed a protocol reads) reports a price that lowers the position's health, a liquidator can repay part of the debt and receive collateral under the protocol's rules. Bitcoin used as collateral usually has to be represented first by a wrapped token such as WBTC (opens in a new tab), cbBTC (opens in a new tab) or tBTC (opens in a new tab), and each one has a different custody or redemption structure.
Key takeaways
- A DeFi loan is a loan made by code: a wallet supplies collateral to a smart contract and borrows another asset, with the collateral worth more than the debt.
- Aave's health factor compares risk-weighted collateral with debt, and a reading below 1 makes a position eligible for liquidation.
- Wrapped Bitcoin is a token that represents Bitcoin; WBTC, cbBTC and tBTC differ in who holds the underlying coins and how redemption works.
- Smart-contract bugs, oracle errors, governance changes, bridge failures and stablecoin de-pegging are risks that a centralized lender's balance sheet does not share in the same form.
- FDIC insurance does not cover crypto assets, and a protocol is not automatically an entity with a bankruptcy estate.
- Tax treatment of wrapping, borrowing and liquidation depends on the specific transaction, so records and a tax professional matter.
What is a DeFi loan?
A DeFi loan means borrowing one crypto asset against crypto deposited into blockchain smart contracts. The term is used broadly and includes services that may not be functionally decentralized (opens in a new tab), so it helps to identify the protocol, the website or app used to reach it, the governance participants and any custodians involved. The protocol sets collateral rules, interest formulas, oracle inputs and liquidation mechanics. A wallet interacts with that code instead of negotiating with a bank or a lender's loan officer.
The appeal is liquidity without selling the underlying crypto. The cost of that choice is that the borrower keeps full price exposure on the collateral while owing a debt that does not shrink when the collateral falls.
How does a DeFi loan work step by step?
On a typical protocol the sequence runs as follows.
- A user connects a blockchain wallet.
- The user supplies an eligible token to the protocol contract.
- The token becomes collateral if the user enables it for collateral use.
- The protocol calculates borrowing capacity from the collateral's value and its collateral factor or loan-to-value (LTV) setting.
- The user withdraws the borrowable asset.
- Interest accrues under the applicable rate model.
- The user repays the debt plus accrued interest.
- After repayment, the user withdraws the collateral, subject to pool liquidity and protocol rules.
Aave (opens in a new tab) works with supplied assets, borrowing, rates that follow pool usage and health monitoring. In Compound III (opens in a new tab), collateral factors determine borrowing capacity, a user borrows the market's base asset through the protocol's withdraw function, and collateral assets do not earn interest. Compound's documentation gives 85% as an example collateral factor for WBTC when borrowing; that figure is an illustration, and each market sets its own current parameters.
Fees sit outside the protocol's interest rate. Network transaction fees, bridge fees, minting and redemption fees all depend on the chain and the token, so each is a separate line to confirm before a transaction.
How are DeFi interest rates set?
Borrow rates on Aave (opens in a new tab) vary with usage of the pool, meaning the share of a pool's supplied funds that has been borrowed. The rate rises gradually below a target level called the kink and rises more sharply above it, which pushes borrowers to repay and suppliers to deposit when a pool runs short of available funds. On Compound, collateral and borrowing parameters are protocol-specific (opens in a new tab), with current rate values shown in each market's interface and configuration data. Governance can change these parameters.
A borrower can therefore see a different rate tomorrow than today, even with no change in the position. No rate figure is printed here because a DeFi rate is only meaningful at the moment it is read. Read the displayed borrow APR immediately before borrowing and record the timestamp, network, market and rate-model version. A centralized lender's advertised rate works differently: Ledn's published Bitcoin-loan APR range (opens in a new tab) is 9.25% to 11.49% as of October 3, 2026, subject to eligibility and jurisdiction, and that range is an advertised range, not an average.
What happens when collateral falls?
The health factor (opens in a new tab) is a ratio built from collateral value, adjusted by each asset's liquidation threshold, divided by debt value. A health factor below 1 makes the position eligible for liquidation. Nothing needs to be missed for that to happen, because no payment schedule exists to miss. Collateral value, debt value, accrued interest or an oracle price can each move the number.
When a position is eligible, a liquidator repays part or all of the eligible debt (opens in a new tab) and receives a proportional amount of collateral plus a liquidation bonus. Aave V3's general close factor is 50% as of October 3, 2026, so a liquidator can repay up to half of the outstanding debt in one liquidation call, and parameters are market-specific and can change. The bonus is the borrower's cost: the collateral sold covers more than the debt repaid.
How a DeFi position moves toward liquidation
- Value changesThe collateral loses value, the debt grows, or an oracle reports a lower price.
- Health factor dropsThe ratio of risk-adjusted collateral to debt falls, and a reading below 1 makes the position eligible.
- Liquidator repays debtA liquidator repays part or all of the eligible debt, up to 50% in one call on Aave V3 as of October 3, 2026.
- Collateral changes handsThe liquidator receives a proportional amount of collateral plus a liquidation bonus, which is the borrower's cost.
Oracles supply the collateral and debt prices behind all of this, and oracle manipulation or failure (opens in a new tab) can cause de-pegging, unwarranted liquidations and insolvency. A wrong, delayed or manipulated price can make a position look safer or riskier than its market value.
Coinbase's USDC loan, which routes to the Morpho protocol, gives a second example of numbers a borrower can compare. The liquidation threshold is 86% LTV and the liquidation penalty is 4.38% (opens in a new tab) as of October 3, 2026.
What is wrapped Bitcoin, and who holds the Bitcoin behind it?
Bitcoin cannot be deposited directly into a contract on another blockchain, so DeFi protocols use tokens meant to represent it. The three most common differ mainly in custody.
WBTC. On August 9, 2024, WBTC custody was announced to move (opens in a new tab) from Bitcoin held in the United States to a multi-jurisdictional, multi-institutional arrangement involving a joint venture with BiT Global, with custody diversified across jurisdictions that include Hong Kong and Singapore. Minting and redemption depend on the issuer's authorized merchant and custodian process.
cbBTC. Coinbase's wrapped assets are backed one-to-one by the underlying asset held in Coinbase custody (opens in a new tab), and the backing is not to be sold, transferred or used for another purpose. Minting and conversion happen through Coinbase-supported workflows and networks.
tBTC. Threshold (opens in a new tab) uses randomly selected operators and threshold cryptography instead of one custodian, and a threshold majority of operators must agree before they can act on deposited Bitcoin. tBTC can be burned and redeemed for BTC (opens in a new tab). Minting and redemption fees were 0.2% in Threshold's documentation, following a governance change effective April 15, 2026.
Wrapped Bitcoin is a representation, not Bitcoin itself. A borrower who posts WBTC as collateral therefore carries the custody risk of that token's structure in addition to the loan's own risks. The questions to ask are who can mint or redeem, who can freeze or restrict tokens, and what the redemption process costs.
Hover or tap a row to highlight it.
| Token | Who holds the Bitcoin behind it | Redemption |
|---|---|---|
| WBTC | Multi-jurisdictional, multi-institutional custody announced August 9, 2024, with a BiT Global joint venture | Depends on the issuer's authorized merchant and custodian process |
| cbBTC | Coinbase custody, backed one-to-one | Coinbase-supported workflows and networks |
| tBTC | Randomly selected operators using threshold cryptography instead of one custodian | Burned and redeemed for BTC; 0.2% fee in Threshold's documentation, effective April 15, 2026 |
What can go wrong with DeFi lending?
Each risk below qualifies the benefit that comes with it: no application, access at any hour, and rules written in code.
- Smart-contract bugs. A code error can permit unauthorized withdrawals, bad accounting or bad debt. Approximately $197 million in assets was exploited (opens in a new tab) in Euler's March 2023 incident.
- Oracle manipulation or failure. Incorrect price data can trigger unfair liquidations or allow under-collateralized borrowing, as covered above.
- Governance changes. Token-based governance or risk administrators can change collateral factors, caps, liquidation bonuses, supported assets and rate models, which means the terms of an open position can change.
- Bridge risk. Cross-chain representations can depend on bridge contracts, validators, operators, custodians or redemption mechanisms.
- Stablecoin de-pegging. If the borrowed or collateral asset loses its intended reference value, debt and collateral calculations can change quickly.
- Liquidity and liquidation failure. Sudden price moves, network congestion or too little liquidator capital can prevent orderly repayment and leave bad debt.
- Dependence on other protocols. A lending protocol relies on the security and price integrity of the tokens, bridges and protocols around it.
- Compliance gaps. Weak or absent anti-money-laundering controls and poor cybersecurity are vulnerabilities for some DeFi services (opens in a new tab).
How does DeFi compare with a centralized crypto lender?
A centralized lender is a company that takes custody of collateral or arranges it, signs a loan agreement with the borrower and applies the agreement's liquidation terms. The comparison below describes categories, and the specific lender's agreement controls.
Hover or tap a row to highlight it.
| Issue | DeFi protocol | Centralized crypto lender |
|---|---|---|
| Collateral holder | Smart contract, protocol-controlled contract or wrapped-asset system | Company, qualified custodian or custody structure named in the agreement |
| Rate setting | Pool-usage model and governance parameters | Contract terms, lender pricing, market conditions and company policy |
| Liquidation | Smart contract and third-party liquidators under protocol rules | Lender or agent under a contract, often with notice and stated remedies |
| Identity checks | Wallet access may need no traditional application, though access points can impose checks | Usually account verification and eligibility checks |
| Legal agreement | Protocol code, governance documents, front-end terms and applicable law | Loan agreement, custody agreement, user terms and applicable law |
| Customer service | Often limited to interface or community channels | Usually designated support and complaint channels |
| Dispute resolution | Code execution may be hard or impossible to reverse | Contract may name courts, arbitration, governing law and remedies |
| Bankruptcy | A protocol is not automatically an entity with a bankruptcy estate | Company insolvency, collateral title and customer claims depend on entity structure and documents |
| Rehypothecation | Protocol design decides whether deposits are pooled, lent or otherwise used | Terms may prohibit or permit lending, pledging or rehypothecation |
Some products sit between the two. In a Coinbase USDC loan (opens in a new tab), Coinbase provides an interface to Morpho, collateral is held on Morpho and the onchain transactions run through a decentralized third-party network. That is a different arrangement from a lender holding collateral on its own balance sheet, and its user agreement (opens in a new tab) sets collateral, security-interest and rehypothecation terms for its own products.
The tradeoff is about where trust sits. A DeFi borrower trusts code, oracles and governance, and has little recourse if one fails. A centralized borrower trusts a company's solvency and conduct, and has a contract and, usually, a place to complain.
What protections are missing?
A DeFi protocol generally does not provide the protections people associate with a bank or brokerage.
- Crypto assets are not insured deposits (opens in a new tab) under FDIC rules.
- SIPC (opens in a new tab) does not protect digital assets that do not qualify as protected securities, or unregistered digital-asset investment contracts.
- No customer service department has the authority to reverse a smart-contract transaction.
- No bank-style supervisor oversees the protocol itself.
- No protocol-level bankruptcy estate supervised by a bankruptcy court exists, and no recovery process is guaranteed if a contract, oracle, bridge or token issuer fails.
A separate company that runs a front end or a custody arrangement may offer contracts, support channels and litigation or arbitration rights, and those rights depend on its terms and applicable law. Platforms where customers buy, sell, borrow or lend crypto assets may lack important investor protections (opens in a new tab) (SEC investor alert, March 23, 2023), and proof of reserves can be a point-in-time snapshot that omits liabilities and is not equivalent to a financial-statement audit.
What does US regulation say?
DeFi has no single federal regulatory status. The rules that apply depend on the activity, the asset, the participants and the economic structure.
- In September 2024 the SEC announced settled charges (opens in a new tab) against Rari Capital and related entities, describing misleading investors, unregistered broker activity and unregistered offerings.
- The CFTC obtained a June 2023 default judgment (opens in a new tab) against Ooki DAO, and the court's order (opens in a new tab) held that the DAO was a "person" under the Commodity Exchange Act and found violations involving leveraged and margined retail commodity transactions, futures commission merchant activity and Bank Secrecy Act obligations.
- Congress disapproved the 2024 digital-asset broker reporting rule (opens in a new tab) under the Congressional Review Act, and Public Law 119-5 left the rule with no legal force or effect as of July 11, 2025.
- Separate IRS digital-asset reporting rules (opens in a new tab) continue for covered brokers and covered transactions, and the final custodial-broker rules described there do not include decentralized or non-custodial brokers.
The repeal of a reporting rule does not remove a taxpayer's underlying tax obligations.
How are wrapping, borrowing and liquidation taxed?
The IRS has not issued single rule that settles every DeFi wrapping, borrowing and liquidation transaction. Wrapping and unwrapping, liquidity-provider transactions, staking and transactions described as digital-asset lending are areas where reporting treatment needed further guidance (opens in a new tab). That is a reporting rule and not a full tax ruling.
A swap, redemption, sale or liquidation may involve a disposition or another tax-relevant event, depending on the assets, the structure, basis, proceeds and applicable law. Taxpayers remain responsible for reporting digital-asset activity even when a DeFi broker provides no Form 1099-DA (opens in a new tab), and the IRS keeps its digital-asset tax resources (opens in a new tab) on one page. Preserve wallet addresses, protocol names, transaction records, basis, fees and liquidation records, and ask a tax professional to classify the specific transaction. For the Bitcoin-loan side of this question, see our guide on whether borrowing against Bitcoin is taxable.
What should a reader ask before interacting?
The numbers below are the ones that change from market to market, so each is worth recording with a date.
Hover or tap a row to highlight it.
| Figure | Value | Date | Qualification |
|---|---|---|---|
| Aave health factor below 1 | Liquidation eligibility | October 3, 2026 | Aave glossary; weights are market-specific |
| Aave V3 general close factor | 50% | October 3, 2026 | Aave Pool documentation; can change |
| Compound documentation example, WBTC borrow collateral factor | 85% | Documentation example | Not a universal current market parameter |
| Coinbase Morpho USDC loan liquidation threshold | 86% LTV | October 3, 2026 | Coinbase collateral page |
| Coinbase Morpho liquidation penalty | 4.38% | October 3, 2026 | Coinbase collateral page |
| tBTC minting and redemption fee | 0.2% | Effective April 15, 2026 | Threshold documentation; excludes network fees |
| Ledn advertised Bitcoin-loan APR range | 9.25% to 11.49% | October 3, 2026 | Advertised range; rate, jurisdiction and eligibility apply |
Questions for the protocol interface, the lender, a regulator or a tax professional:
- Which exact protocol, network and front end is being used?
- Is the collateral token wrapped, and who holds and redeems the underlying Bitcoin?
- What are the collateral factor, liquidation threshold, liquidation bonus or penalty and close factor?
- Which oracle provider supplies prices, and what happens if it fails?
- What are the current borrow rate, pool usage and rate model?
- What do transactions, bridging, minting and redemption cost?
- Who holds governance power, and how are parameters changed?
- Which asset repays the loan, and what conditions apply to withdrawing collateral?
- Which legal entity can be contacted if funds are lost?
Customers are advised by the CFTC to research thoroughly (opens in a new tab), understand the rights attached to a token and be wary of promises or guarantees of future value.
Check what you know about DeFi loans
Frequently asked questions
Is a DeFi loan over-collateralized?
Yes on the protocols described here: Aave and Compound (opens in a new tab) set collateral value and protocol parameters so that collateral supports the debt. The exact factors differ by market, token and date.
Who liquidates the collateral in a DeFi loan?
A third-party liquidator repays qualifying debt and receives collateral plus a bonus under the protocol's liquidation rules (opens in a new tab). The borrower is not contacted first, and the bonus is paid from the borrower's collateral.
Is Bitcoin insured in DeFi?
FDIC insurance does not cover crypto assets (opens in a new tab), and SIPC protection (opens in a new tab) generally does not extend to digital assets that fail to qualify under the Securities Investor Protection Act. Any protection a user has comes from the terms of a specific company or product.
Does a DeFi loan require identity checks?
Wallet access to a protocol may need no traditional application, but front ends and access points can impose checks. Absence of identity checks does not mean legal obligations are absent, as the Ooki DAO judgment (opens in a new tab) shows.
Is a DeFi loan taxable?
The IRS requires taxpayers to report taxable digital-asset activity (opens in a new tab). Treatment of wrapping, borrowing and liquidation can turn on transaction details, which makes a tax professional's review of the specific facts the safer course.
Where to go next
For the loan mechanics that DeFi and centralized lenders share, the Bitcoin borrowing series covers how Bitcoin-backed loans work, liquidation, lender risks, taxes and what to check before using a lender. For a tax professional or attorney near the reader, the Inversado directory lists financial professionals by city and category.
Terms in this guide
Tap a term to see what it means.
Over-collateralized. A loan whose collateral is worth more than the debt.
Smart contract. Code on a blockchain that carries out a loan's rules without a loan officer.
Collateral factor / loan-to-value (LTV). The setting a protocol uses to turn the value of collateral into borrowing capacity.
Health factor. Aave's ratio of risk-adjusted collateral value to debt value; a reading below 1 makes a position eligible for liquidation.
Liquidation threshold. The asset-specific weight applied to collateral value when a protocol calculates the health factor.
Close factor. The share of an eligible debt a liquidator can repay in one liquidation call; 50% generally on Aave V3 as of October 3, 2026.
Liquidation bonus. The extra collateral a liquidator receives for repaying debt, paid from the borrower's collateral.
Oracle. The price feed a protocol reads to value collateral and debt.
Utilization. The share of a pool's supplied funds that has been borrowed.
Kink. The target utilization level above which a protocol's borrow rate rises more sharply.
Wrapped Bitcoin. A token on another blockchain meant to represent Bitcoin, such as WBTC, cbBTC or tBTC.
De-pegging. An asset losing its intended reference value.
Rehypothecation. A lender's reuse of pledged collateral for its own lending or pledging, where its terms permit.
Inversado explains how financial products and rules work. It is education, not investment, tax or legal advice for your situation. Rates, rules and terms change; check the current figures with the lender, the regulator or a licensed professional before you act.
