An overview of the core principles and mechanisms that power decentralized lending and borrowing, enabling users to interact with financial services without traditional intermediaries.
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Lending and Borrowing in DeFi: An Overview
A technical breakdown of the mechanisms, risks, and major protocols in decentralized lending markets.
Chainscore © 2025
core_concepts
Foundational Concepts
01
Overcollateralization
Overcollateralization is the requirement to deposit crypto assets worth more than the loan value to mitigate price volatility risk.
- Borrowers must lock assets like ETH as collateral to borrow a stablecoin like DAI.
- Protocols use Loan-to-Value (LTV) ratios, e.g., 150%, to determine borrowing limits.
- This protects lenders from defaults, ensuring system solvency even if collateral value drops.
02
Liquidation
Liquidation is the automated process of selling a borrower's collateral if its value falls below a required threshold.
- Triggered when the collateral's value nears the borrowed amount, e.g., due to market crashes.
- Liquidators are incentivized with discounts to repay the debt and seize collateral.
- This mechanism maintains protocol health by preventing undercollateralized loans.
03
Interest Rate Models
Interest rate models algorithmically adjust borrowing and lending rates based on supply and demand within a pool.
- Utilizes models like Compound's jump-rate model to optimize capital efficiency.
- High utilization rates increase borrowing costs to incentivize repayments or more supply.
- This dynamic pricing ensures liquidity is available while rewarding lenders appropriately.
04
Flash Loans
Flash loans are uncollateralized loans that must be borrowed and repaid within a single blockchain transaction.
- Enable complex arbitrage, collateral swapping, or self-liquidation without upfront capital.
- Popular on Aave, where users exploit price differences across DEXs for profit.
- They democratize access to large capital but require smart contract expertise to execute safely.
05
Money Markets
Money markets are decentralized platforms where users can supply assets to earn interest or borrow assets by providing collateral.
- Pools like those on Compound aggregate liquidity from many lenders.
- Suppliers receive interest-bearing tokens (cTokens) representing their share.
- These create efficient markets for capital, offering passive income and accessible credit.
06
Governance Tokens
Governance tokens grant holders voting rights to propose and decide on protocol changes, such as interest rates or new assets.
- Examples include COMP (Compound) and AAVE (Aave), which distribute control to the community.
- Holders can vote on risk parameters, fee structures, and treasury management.
- This decentralizes decision-making, aligning the protocol's evolution with user interests.
The Borrowing Lifecycle
A step-by-step overview of the process for borrowing assets in a decentralized finance (DeFi) protocol.
1
Step 1: Connect Wallet & Deposit Collateral
Initialize the process by connecting a Web3 wallet and funding a collateral position.
Detailed Instructions
To begin borrowing, you must first connect a non-custodial wallet like MetaMask to the DeFi protocol's interface. The core principle is over-collateralization, meaning you must deposit assets worth more than you intend to borrow to secure the loan against price volatility. This creates a Collateral Factor or Loan-to-Value (LTV) ratio, which is a protocol-specific limit (e.g., 75% for ETH).
- Sub-step 1: Connect Wallet: Click 'Connect Wallet' on the dApp and authorize the connection from your wallet extension (e.g., MetaMask). Ensure you are on the correct network (e.g., Ethereum Mainnet, Arbitrum).
- Sub-step 2: Select Collateral Asset: Navigate to the 'Supply' or 'Markets' section. Choose an asset to deposit, such as WETH. Check the protocol's documentation for the specific collateral factor for that asset.
- Sub-step 3: Approve & Deposit: First, you must grant the protocol's smart contract permission to access your tokens via an
approvetransaction. Then, execute adeposittransaction specifying the amount.
javascript// Example: Approving a token contract (WETH) for a lending protocol await wethContract.approve(lendingPoolAddress, ethers.utils.parseEther("10.0"));
Tip: Always verify the contract addresses from the protocol's official sources to avoid phishing scams. For example, Aave's LendingPool address on Ethereum Mainnet is
0x7d2768dE32b0b80b7a3454c06BdAc94A69DDc7A9.
2
Step 2: Determine Borrowing Capacity & Request Loan
Calculate how much you can borrow and execute the borrow transaction.
Detailed Instructions
Once collateral is deposited, your borrowing power is calculated based on the collateral's value and the protocol's Loan-to-Value (LTV) ratio. For instance, if you deposit $10,000 of ETH with a 75% LTV, your maximum borrowable amount is $7,500 worth of another asset. It's crucial to monitor your Health Factor, a numerical representation of your loan's safety; if it drops below 1.0 due to market movements, your position may be liquidated.
- Sub-step 1: Check Borrow Limits: In the protocol's UI, your dashboard will display your total collateral, borrowing power, and current health factor.
- Sub-step 2: Select Borrow Asset: Choose the asset you wish to borrow (e.g., USDC, DAI). Note the stable vs. variable interest rate options and the current APY.
- Sub-step 3: Execute Borrow Transaction: Specify the borrow amount and submit the transaction. The borrowed assets will be sent directly to your wallet.
solidity// Simplified borrow function call in a smart contract function borrow(address asset, uint256 amount, uint256 interestRateMode, uint16 referralCode, address onBehalfOf) external; // interestRateMode: 1 for Stable, 2 for Variable
Tip: Borrowing near your maximum LTV is risky. Maintain a health factor well above 1.5 (e.g., 2.0 or higher) to create a buffer against market dips and avoid liquidation.
3
Step 3: Manage Debt & Accruing Interest
Monitor and optionally repay debt during the loan period as interest accrues.
Detailed Instructions
After borrowing, your debt begins to accrue interest in real-time, compounded per block. The interest rate can be variable (fluctuates with market demand) or stable (pegged to a long-term average). You must actively manage your position by tracking the increasing debt balance and the fluctuating value of your collateral, which affects your Health Factor. Some protocols allow you to swap interest rate modes (e.g., from variable to stable) if market conditions change.
- Sub-step 1: Monitor Position Dashboard: Regularly check your position on the protocol's interface. Key metrics to watch are your current debt balance, health factor, and collateral value.
- Sub-step 2: Make Partial Repayments (Optional): You can repay a portion of the principal plus accrued interest at any time without closing the entire position. This improves your health factor.
- Sub-step 3: Handle Interest Payments: Interest is typically added to your debt balance (debt interest). You don't need to make periodic payments, but the growing debt increases liquidation risk.
bash# Example CLI command to check a position's health factor using a protocol's subgraph (The Graph) query { user(id: "0xYourWalletAddress") { healthFactor totalBorrowsInETH } }
Tip: Set up alerts for your health factor using services like DeBank or Zapper to get notified if it falls below a safe threshold you define, such as 1.8.
4
Step 4: Repay Loan & Withdraw Collateral
Close the position by repaying the debt in full to reclaim your locked collateral.
Detailed Instructions
The final phase involves repaying the borrowed amount plus all accrued interest to unlock your initial collateral. You must repay using the same borrowed asset. First, ensure you have sufficient funds of that asset in your wallet. After a successful repayment, your debt balance is reduced to zero, your borrowing power is restored, and your Health Factor becomes effectively infinite, removing the liquidation risk. You can then withdraw some or all of your collateral.
- Sub-step 1: Approve Repayment: Grant the protocol permission to pull the repayment tokens (e.g., USDC) from your wallet via an
approvetransaction for the total amount owed. - Sub-step 2: Execute Repay Transaction: Call the
repayfunction on the protocol's contract. You can often choose to repay the full amount or a specific sum. - Sub-step 3: Withdraw Collateral: Once the debt is cleared, navigate to the 'Withdraw' section for your collateral asset. Specify the amount to withdraw and confirm the transaction.
javascript// Example: Repaying a full debt in a smart contract interaction await lendingContract.repay(assetAddress, ethers.constants.MaxUint256, 2, msg.sender); // Using MaxUint256 repays the full debt for the specified interestRateMode (2 for Variable)
Tip: Always perform a small test transaction first if repaying a large sum. Verify the transaction on a block explorer like Etherscan to confirm the debt balance is updated to zero before attempting to withdraw your full collateral.
Major Lending Protocols Compared
Comparison of key features and metrics for leading DeFi lending platforms.
| Protocol | Total Value Locked (TVL) | Native Token | Interest Rate Model | Unique Feature |
|---|---|---|---|---|
Aave | $12.5B | AAVE | Algorithmic (Variable/Stable) | Risk-Adjusted Rates, Flash Loans |
Compound | $3.8B | COMP | Utilization-Based | Governance-Driven Upgrades |
MakerDAO | $8.1B | MKR | Stability Fee (DSR) | Overcollateralized DAI Stablecoin |
Liquity | $850M | LQTY | Fixed (0% borrowing) | Interest-Free Loans, Recovery Mode |
Euler Finance | $320M | EUL | Isolated Risk Pools | Permissionless Listings |
Morpho Blue | $1.2B | MORPHO | Customizable by Pool Creator | Optimized Rates via MetaMorpho Vaults |
Participant Perspectives
Getting Started with DeFi Lending & Borrowing
DeFi lending and borrowing allows you to earn interest on your crypto assets or take out loans without a traditional bank. Instead of a central authority, smart contracts on blockchains like Ethereum automate the process. You interact with protocols like Aave or Compound by connecting a digital wallet.
Key Points
- Supplying Liquidity: You deposit assets like ETH or USDC into a protocol's liquidity pool to become a lender. In return, you earn interest, often paid in the protocol's governance token (e.g., Aave's AAVE).
- Overcollateralized Loans: To borrow, you must deposit crypto worth more than the loan amount as collateral. For example, to borrow $1,000 of DAI, you might need to lock $1,500 worth of ETH. This protects the protocol if the collateral's value drops.
- Use Case - Leverage: A common use is to borrow against your existing crypto to buy more without selling, a strategy called leveraging. However, this increases risk if prices fall sharply.
Example
When using Aave, you would connect your MetaMask wallet, select an asset to supply (like USDC), and approve the transaction. Your supplied assets start earning variable interest immediately. To borrow, you select a borrowable asset, see your borrowing power based on your collateral, and then take out the loan, all within a few clicks.
key_risks
Critical Risks and Mitigations
An overview of the primary vulnerabilities in decentralized finance lending and borrowing protocols, along with strategies to manage and reduce these risks.
01
Smart Contract Risk
Smart contract vulnerabilities are flaws in the code that can lead to fund loss. These bugs are often exploited by hackers before developers can patch them.
- Reentrancy attacks allow repeated withdrawals before balance updates.
- Logic errors in interest rate models or liquidation engines.
- The 2022 Nomad Bridge hack, resulting in a $190M loss, stemmed from a contract initialization error.
- This matters because users deposit assets assuming the code is flawless, making rigorous audits and bug bounties essential for trust.
02
Oracle Failure
Oracle manipulation occurs when the price feeds used by protocols are inaccurate or attacked, leading to improper liquidations or unsustainable borrowing.
- Data feed latency during market volatility causes stale prices.
- Direct manipulation via flash loans to skew asset valuations.
- The 2020 bZx attack used flash loans to manipulate oracle prices for profit.
- This is critical as oracle integrity is the foundation for calculating collateral ratios and triggering timely, fair liquidations to protect the system.
03
Liquidation Risk
Forced liquidation happens when a borrower's collateral value falls below the required threshold, potentially at a loss due to market conditions.
- Liquidation penalties can be high, eroding user equity.
- Network congestion may delay transactions, causing worse prices.
- During the 2021 crypto crash, many positions were liquidated at suboptimal prices due to gas wars.
- Users must actively manage their health factor and understand the specific liquidation mechanisms of each protocol to avoid unexpected losses.
04
Governance and Centralization
Protocol governance risk involves decision-making power concentrated among a few token holders or developers, potentially acting against the community's interest.
- Proposal manipulation through token accumulation or voter apathy.
- Admin key risk where multi-sig signers could upgrade contracts maliciously.
- The temporary freezing of funds by the MakerDAO foundation in 2020 highlighted centralization concerns.
- This matters as decentralized governance is a core DeFi promise; transparent processes and progressive decentralization are key mitigations.
05
Systemic and Contagion Risk
Financial contagion refers to the interconnectedness of DeFi protocols, where the failure of one can cascade and threaten the entire ecosystem.
- Over-collateralization loops where the same asset is re-used across platforms.
- Liquidity crunches when a major protocol fails, causing panic withdrawals.
- The collapse of the Terra/LUNA ecosystem triggered massive liquidations and insolvencies across multiple lending platforms.
- This underscores the need for users to diversify exposure and for protocols to implement circuit breakers and robust risk assessments.
Frequently Asked Questions
A decentralized lending protocol is a smart contract-based platform that enables users to lend and borrow digital assets without a traditional intermediary. It operates through algorithmic interest rate models that adjust based on supply and demand for each asset. Users supply assets to a liquidity pool to earn interest, while borrowers can take out overcollateralized loans by depositing crypto as collateral. For example, on Aave, you might supply USDC to earn 3% APY, while a borrower could deposit $150 worth of ETH to borrow $100 worth of DAI. This system is secured by blockchain technology, ensuring transparency and programmatic enforcement of terms.