Overview

Lending and borrowing in DeFi allow users to earn interest by supplying assets to lending protocols or accessing liquidity by borrowing funds against their crypto holdings.

In traditional banking, individuals deposit funds into a bank, which then lends those funds to borrowers at a higher interest rate, profiting from the spread. In Web3, lending protocols replace banks by allowing users to lend assets directly to a decentralized lending pool and earn interest while borrowers lock up crypto as collateral to take out loans.

Since DeFi borrowers are anonymous and lack credit scores, they cannot take out undercollateralized loans. Instead, they must first deposit sufficient assets into the protocol as collateral before borrowing.

Some key terms include:

  • Lending: The act of supplying assets to a DeFi lending protocol to earn interest.
  • Borrowing: Taking out a loan by locking up crypto as collateral to access liquidity.
  • Loan-to-Value (LTV) Ratio: The percentage of borrowed funds relative to deposited collateral.
  • Utilization Rate: The percentage of supplied assets that have been borrowed, directly influencing interest rates—higher utilization increases borrowing costs while lower utilization reduces them.
  • Liquidation: The automatic sale of collateral when a borrower’s LTV ratio exceeds the liquidation threshold.

How Lending & Borrowing Works

A user could deposit $1,000 worth of BTC into a lending protocol as collateral and then borrow USDC against it. They can then use the borrowed USDC in various ways:

  • Reinvest in BTC: Convert the borrowed USDC back into BTC and lend it out again to increase yield exposure (this would be termed “leveraged yield farming”).
  • Pay Off Expenses: Use the borrowed funds for personal or business expenses while still holding their BTC.
  • Deploy in DeFi Strategies: Provide liquidity, stake, or use the borrowed USDC to earn additional yield elsewhere.

At the same time, the borrower still owns their original BTC, meaning that if BTC appreciates in value, they benefit from the price increase while using the borrowed funds.

However, if BTC’s price drops significantly, they may risk liquidation.

Lending & Borrowing Key Considerations

Some key considerations relating to lending & borrowing projects include:

Interest Rates

DeFi lending platforms use dynamic interest rates that fluctuate based on supply and demand. Unlike traditional banks, where central authorities set interest rates, DeFi protocols adjust borrowing and lending rates algorithmically.

These fall into two categories:

  • Variable interest rates: the most common choice, where rates adjust based on supply and demand of each asset.
  • Fixed interest rates: more challenging in Web3 due to market volatility, but +++

The utilization rate refers to the percentage of supplied assets that have been borrowed. For example, if $10,000 worth of USDC has been supplied to the platform, and $5,000 of that has been borrowed, USDC’s utilization rate would be 50%. Each asset, therefore, has its own utilization rate, and the interest rate model may vary based on how liquid the asset is.

DeFi lending platforms use dynamic interest rates based on supply and demand, adjusting for market volatility. Learn how variable and fixed rates work and the impact of utilization rates on borrowing and lending costs.

Interest rate volatility can be a concern, as fluctuations in the cryptocurrency markets can rapidly change the utilization rate, causing borrowing costs to spike or lending yields to drop unexpectedly.

This can make it difficult for borrowers to predict their repayment costs and for lenders to estimate their returns. In extreme cases, sudden increases in interest rates may force borrowers to repay loans prematurely to avoid unsustainable costs.

Liquidations

Liquidation occurs when a borrower’s collateral becomes insufficient to cover their loan, usually due to a drop in the collateral’s value. Unlike traditional finance, where credit scores determine borrowing limits, DeFi loans are

The Loan-to-Value (LTV) ratio typically determines when a liquidation is triggered and presents a percentage of a borrower’s loan relative to their collateral. For example, if someone deposits $1,000 worth of BTC and borrows $600 of USDC, their LTV is 60%.

Typically, when the LTV exceeds the liquidation threshold, a liquidation is triggered. This threshold is set below 100% because cryptocurrency prices can be volatile, and a sudden drop in collateral value could leave lenders with insufficient funds to cover outstanding loans. By enforcing liquidation before the LTV reaches 100%, protocols ensure that loans remain overcollateralized and mitigate the risk of bad debt.

If BTC’s value drops and the health factor falls below 1, the borrower’s collateral is liquidated to repay the loan.

Flash Loans

Flash loans refer to a special type of loan worth understanding, whereby users can borrow funds without providing collateral, as long as the loan is borrowed and repaid within a single blockchain transaction.

If the borrower fails to repay the loan within the same transaction, the entire transaction is reverted, ensuring that no funds are lost.

Flash loans have gained popularity as they enable traders to capitalize on arbitrage opportunities across multiple DeFi protocols without upfront capital. For instance, a trader can use a flash loan to borrow funds from one platform, purchase an asset on another where it’s undervalued, sell it on a third platform at a higher price, and repay the loan (all within a single transaction).

That being said, they’re also a popular method of attack, such as in the $197M Euler Finance exploit.

A reason for this is that the large transactions on-chain can cause instability for DeFi protocols, which can be exploited, such as distorting pricing by imbalancing liquidity pools on a decentralized exchange.

Other concepts

  • Magnified Exposure: Users can lend out assets as collateral and take out.
  • Liquidation Risk: If the collateral value drops or the borrowed asset price rises, liquidation may be triggered.
  • Interest Rate Volatility: Borrowing and lending rates fluctuate based on supply and demand.
  • Smart Contract Risk: Even well-known lending protocols like Aave and Compound carry security risks.

Popular Lending & Borrowing Platforms

A few popular liquidity provisioning platforms include:

  • Uniswap: A popular, long-standing DEX that operates across 30+ networks. Their V4 upgrade introduced “Hooks” which provide developers with more customization over DEXs, including the ability to introduce new trading strategies.
  • PancakeSwap: A leading DEX on BNB Chain that’s also 7+ other networks, offering low-fee trading, yield farming, and lottery-style rewards through its native CAKE token.
  • Raydium: A Solana-based DEX and AMM that provides high-speed, low-cost swaps, concentrated and constant product liquidity pools, and permissionless yield farming.