Decentralized Lending: How does it work & what is

Updated: Jun 9

In the traditional financial system, borrowers usually take loans from single parties like banks. Decentralized Lending is different since it allows everyone to take a loan if set criteria are met. With protocols like or, you can lend and borrow your capital. Such lending protocols provide loans trustless and without intermediaries - based on a smart contract infrastructure holding liquidity. If over-collateralized with another token, a borrower can obtain a loan from the protocol.

Author: David RJ Brodhagen

Furthermore, the lending protocol enables the lender to earn interest. One crucial indicator to measure Lending protocols' liquidity is the so-called Total Value Locked (TVL). Lending protocols are among the most significant contributors for locking crypto assets among all decentralized apps (DApps).

Figure 1: How Lending works

Let's start with Lending:

Lending Mechanism

Cryptocurrency deposits made to lending protocols create derivative tokens representing the user's balance. Depending on the protocol you are using, those tokens appreciate in value with interest or retain a value equivalent to the underlying asset but increase in amount. Users can mint those collateral tokens by supplying holdings to the protocol or redeeming them for the underlying asset.

Interest Rate

The interest rate model is simply the relationship between the available liquidity in the asset pool and the demand to borrow. Each market has interest rates determined by the supply and demand of the underlying asset.When there's an increase in demand for borrowing a specific asset, the interest model generates more income for depositors while simultaneously reducing total available liquidity.

Next, let’s take a closer look at the Borrowing side:

Borrowing Mechanism

After supplying an asset to the protocol, depositors can use their collateral tokens (borrowing power) to borrow other cryptocurrencies. The maximum borrow-able amount for the user is based on the minimum collateralization level. If the Vault goes below this level, it is considered undercollateralized and is subject to liquidation. As such, depending on the price volatility of your collateral asset, you should consider a higher collateral ratio than the minimum required.


Liquidation is when a smart contract sells crypto assets to cover the debt generated from a loan. The aim is to protect the lender's liquidity from an undercollateralization of the pool. If a borrower's collateral value falls under a certain liquidation threshold (Liquidation Ratio), the protocol will allow someone else to repay the debt at a discount in return for the collateralized asset. As such, liquidation works as a penalty for borrowers and protects the protocol's sustainability.

Flash Loan

A flash loan is a relatively new type of uncollateralized lending that has gained popularity across various Decentralized Finance Protocols. Unlike traditional loans, flash loans do not require collateral, which means they do not need any upfront capital. The condition is that the borrower must take and also pay back the loan in one atomic transaction (thus in one block); otherwise, the smart contract reverses the transaction - so it's like the loan never happened in the first place.

DeFi 2.0: How builds on top of existing protocols

For providing liquidity on protocols like, Compound or Aave, lenders receive an LP token that yields interest on the provided liquidity. Users can use these tokens as collateral to take a loan on Abracadabra is a lending platform that accepts interest-bearing tokens as collateral in return for a cross-chain stablecoin (MIM).

Magic Internet Money (MIM)

The Magic Internet Money Token (MIM) is an algorithmic over-collateralized stablecoin backed by interest-bearing tokens (LP shares & tokens). The protocol specifies which interest-bearing assets can get used as collateral. Interest rates vary depending on the collateral token.

The amount of MIM that a borrower can get is determined by two primary factors: the Loan-to-Value ratio (LTV) and the original maximum MIM allocation to that collateral. Interest rates vary depending on the collateral token (see Figure 2).

Figure 2: Abracadabra Interest Rates


The Spell Token (SPELL) is the governance token of Abracadabra. The maximum supply is 210 billion. Protocol fees (borrow fees, interest fees, and 10% of the liquidation fee) get paid in the form of SPELL tokens and distributed to staked SPELL (sSPELL) holders. Furthermore, holders can participate in protocol’s governance proposals.

Passive Income

Freelancers can stake, borrow or farm on the protocol:

  • Stake: Convert SPELL into interest-bearing sSPELL

  • Farm: Stake LP shares (ETH-SPELL) or (ETH-MIM) to earn SPELL

  • Borrow: Collaterize LP shares or tokens to borrow MIM.

By reusing MIM, freelancers can purchase a new interest-bearing token through liquidity mining and borrow MIM through it again. After understanding the liquidation risks, they might leverage their original stake through multiple loops and generate APY on a significantly higher stake.

About is the first token-based accounting solution that offers seamless fiat-to-crypto invoicing. At, our mission is to eliminate the gap between traditional and blockchain-based accounting. We provide a self-explanatory user interface with a clean and modern look that naturally supports your workflow. Furthermore, we will integrate support for the most popular networks like Bitcoin, Bitcoin Lightning, Ethereum, Binance Smart Chain, Polygon, and more.


David RJ Brodhagen is COO and co-founder at Before, he worked in the blockchain ecosystem for two years. Besides studying Business Administration, he leads the Blockchain Initiative at the Frankfurt School of Finance and Management. You can contact him via email and LinkedIn.