Peer-to-Pool Lending

The core mechanism where lenders (suppliers) deposit assets into a shared smart contract, creating a collective fund. Borrowers draw from this single pool, not from individual lenders. This creates fungible liquidity represented by liquidity provider (LP) tokens, which accrue interest. Examples include Aave's aTokens and Compound's cTokens.

Interest rates are not negotiated but are determined algorithmically based on real-time supply and demand within the pool. Key models include:

• Utilization Rate Model: Rates increase as the pool's borrowed fraction rises.
• Stable vs. Variable Rates: Some protocols offer borrowers a choice between fluctuating variable rates or fixed stable rates. This automated pricing is a defining feature of DeFi money markets.

To secure loans in a trustless environment, borrowers must deposit collateral worth more than the loan value. This collateral factor or loan-to-value (LTV) ratio (e.g., 75% for ETH) protects the pool from insolvency if the collateral's value drops. If the collateral value falls below a threshold, it can be liquidated automatically to repay the pool.

An automated process to maintain pool solvency. When a borrower's health factor (collateral value / borrowed value) falls below 1, their position becomes eligible for liquidation. Liquidators can repay part of the debt in exchange for the collateral at a discount, ensuring the pool remains whole. This is a critical risk management feature.

Key parameters like interest rate models, acceptable collateral assets, and LTV ratios are not static. They are typically managed by a decentralized autonomous organization (DAO) holding governance tokens (e.g., AAVE, COMP). Token holders vote on proposals to adjust these parameters, evolving the protocol's risk and reward structure.

Lenders earn yield primarily from interest paid by borrowers. This is often supplemented by liquidity mining incentives, where the protocol distributes its native governance tokens to suppliers and borrowers to bootstrap liquidity. Yield can thus be a combination of supply APY and reward APY, creating complex yield farming strategies.

The foundational component where user-supplied assets are aggregated. Each supported cryptocurrency (e.g., ETH, USDC) has its own dedicated pool. Liquidity providers (LPs) deposit assets into these pools and receive liquidity provider tokens (LP tokens) representing their share and earning potential.

Interest rates are not set by a central entity but are calculated on-chain using a money market model. Key models include:

• Utilization Rate Model: Rate increases as the pool's borrowed fraction rises.
• kinked rate model: Introduces a steep rate increase after a high utilization threshold (e.g., 80%) to incentivize repayments or more supply.

A core security mechanism requiring borrowers to deposit collateral worth more than the loan value. This protects the pool from insolvency due to price volatility. If the collateral's value falls below a liquidation threshold, the position is automatically liquidated by keepers to repay the debt.

A non-negotiable process triggered when a borrower's health factor (a ratio of collateral to debt) falls below 1. Liquidators can repay a portion of the undercollateralized debt in exchange for seizing the borrower's collateral at a discount, ensuring the pool remains solvent.

Protocol parameters (e.g., interest rate curves, collateral factors) are typically controlled by a decentralized autonomous organization (DAO) holding governance tokens. This allows the community to vote on risk management and protocol upgrades, often executed via a timelock contract for security.

Supplier yield is generated from borrower interest payments. The displayed APY (Annual Percentage Yield) is dynamic and comprises:

• Supply APY: Interest earned on deposited assets.
• Incentive APY: Additional rewards paid in a governance token to bootstrap liquidity. Rates update in real-time based on pool utilization.

An individual or entity that deposits assets into a lending pool. LPs supply the capital that borrowers draw from. In return, they earn yield generated from:

• Interest paid by borrowers.
• Protocol-specific incentive tokens.
• A portion of platform fees. Their returns are passive but carry risks like impermanent loss (if the pool contains volatile assets) and smart contract risk.

The fundamental security model of most DeFi lending. To borrow assets, a user must deposit collateral of greater value than the loan. This creates a collateralization ratio (e.g., 150%). If the value of the collateral falls below a liquidation threshold, the position can be automatically liquidated by keepers to repay the loan, protecting the liquidity in the pool.

The automated process of selling a borrower's collateral when their health factor or collateralization ratio falls below a safe threshold. This is a critical risk management feature that ensures the solvency of the lending pool. Liquidators are incentivized with a bonus to repay part of the debt and seize the collateral, ensuring bad debt is minimized.

Protocols often distribute native governance tokens (e.g., COMP, AAVE) to LPs and borrowers as additional incentives. This practice, called yield farming or liquidity mining, bootstraps liquidity and decentralizes governance. The total return for an LP is thus APY = Base Interest Rate + Incentive Token Rewards.

Smart contract logic that dynamically adjusts borrowing costs. Common models include:

• Utilization Rate Model: Rates increase as more pool capital is borrowed to incentivize repayments or more deposits.
• Kinked Rate Model: Features a sharp increase in rates after a high utilization threshold (e.g., 90%).
• Stable/Variable Rates: Some protocols offer a choice between stable and fluctuating rates.