You transfer the coins into a contract or a custodian account usually. But yes, they are locked up for the duration aka not yours anymore in the private key/wallet sense.
Why wouldn't you just sell your coins at full value instead of using this "loan"?
- People hope that the value of the underlying coins will rise in the meantime. (It may, of course, also fall but crypto enthusiasts usually don't worry too much about that)
- Quite often the volume available is not that high for many coins, so if it hovers around (say) USD 100 per coin but you want to sell 10 million coins, you would not be able to get 100*10 million is 1 billion USD for them. The market simply can't absorb that much, but if you use the coins as collateral you won't "sell" them and thus won't impact the market price.
- Selling things of value can have tax implications in certain jurisdictions, which you can avoid by lending against those things instead.
You're not selling the coins, you're pawning them.
Also you wouldn't have to pay capital gains tax in countries that require that on crypto sales.