How do DeFi lending and borrowing work?

How does a DeFi lending pool work?

A DeFi lending protocol is not a matchmaking service between one lender and one borrower. Everyone's deposits go into a shared pool for each token, held by smart contracts. On Aave, for example, supplied tokens are made available to borrowers and the supplier receives aTokens whose balance grows at the current supply rate.

Borrowers draw from the same pool, but only after depositing collateral. Interest paid by borrowers flows back to suppliers, minus a slice the protocol keeps. Nobody checks your income or credit history. The only question the code asks is whether your collateral is worth enough.

Why do DeFi loans need more collateral than you borrow?

Because the protocol knows nothing about you. The Bank for International Settlements explains that DeFi lending is overcollateralized for the same reason crypto-backed stablecoins are: anonymous transactions offer no basis for trust, and the crypto-assets used as collateral are highly volatile. Without a court or a credit file to fall back on, the loan is only as safe as the collateral behind it.

Two ratios govern how much you can take out. The loan-to-value (LTV) ratio caps how much you can borrow against a given collateral. The liquidation threshold, set by Aave governance for each collateral asset, is the line beyond which the position can be liquidated. Both are percentages of the collateral's value and vary by asset.

What is a health factor, and when does liquidation happen?

Aave summarizes a borrower's safety margin in one number. Its documentation defines the health factor as total collateral value multiplied by the weighted-average liquidation threshold, divided by total borrow value. Above 1 the position is safe from liquidation; below 1 it can be liquidated.

When the health factor drops below 1, outside actors called liquidators repay part of the debt and receive the equivalent value of collateral plus a liquidation bonus, taken from the borrower's collateral. Aave's help center says up to 50% of the debt can be liquidated at once when the health factor is above 0.95 and both collateral and debt exceed $2,000, and up to 100% when the health factor is 0.95 or lower, or either side is below $2,000. ethereum.org notes that bots compete to spot these opportunities first, because the bonus is a profit.

How are DeFi interest rates set?

Rates follow a formula, not a committee. Aave's documentation describes rates that adjust with the utilization rate — the proportion of supplied tokens currently borrowed. Its model has two slopes: one that applies until utilization reaches an "optimal" level, and a second that applies above it, up to 100%. In practice this means borrowing gets more expensive as more of a pool is lent out, with a different slope once the optimal level is passed.

The rate suppliers earn is derived from what borrowers pay and the reserve factor, the portion of interest that goes to the protocol's treasury. That is why the supply rate is lower than the borrow rate on the same pool. Both change as utilization changes, so the rate you see today is not the rate you will get next month.

What are flash loans?

A flash loan is a loan with no collateral at all, made possible because a blockchain transaction either completes in full or not at all. Aave's guide describes it as borrowing an asset on condition that the amount plus a fee is returned before the transaction ends; if not, the entire transaction is reverted as if it never happened. Aave's fee was set at 0.05% at deployment, adjustable by governance — 0.05% of a hypothetical $1,000,000 loan is $500.

The Financial Stability Board notes flash loans are used mostly for arbitrage and trading, but also by attackers to borrow huge sums and manipulate prices within one transaction. We cover those attacks in the main risks of DeFi.

What mistakes do beginners make with DeFi loans?

• Borrowing up to the maximum. A position opened right at the limit can be liquidated by an ordinary daily price swing.
• Not watching the position. Liquidations run around the clock. Set alerts and keep spare funds ready to repay or add collateral.
• Forgetting that rates float. A cheap loan can become expensive when utilization spikes.
• Looping leverage. Borrowing, buying more collateral and borrowing again multiplies exposure. The BIS warns that when collateral falls, leveraged investors are forced to sell, pushing prices down further.
• Ignoring what the price feed is. Liquidations depend on an oracle; Aave lists oracle risk alongside smart-contract and collateral risk.