Loan-to-Value (LTV)

The LTV ratio is a dynamic risk parameter set by a protocol's governance or risk team, not a fixed rule. It varies by:

• Collateral Asset: Stablecoins like USDC may have an 80-90% LTV, while volatile assets like ETH might be 70-75%.
• Market Conditions: Protocols can adjust LTVs during high volatility to protect the system.
• Oracle Reliability: Assets with less reliable price feeds are assigned more conservative LTVs. This parameter directly defines the maximum borrowing power against deposited collateral.

Closely related to LTV is the Liquidation Threshold (LT), a higher percentage at which a position becomes eligible for liquidation. This creates a safety buffer.

• Example: If collateral is $100 of ETH with an LTV of 70% and an LT of 80%, you can borrow up to $70. If the value of your ETH falls so your loan is now worth 82% of your collateral, your position is under-collateralized and can be liquidated. The gap between LTV and LT is the liquidation buffer, giving users time to add collateral or repay debt.

The Health Factor is a real-time, user-facing metric derived from LTV/LT that shows a position's safety.

• Formula: Health Factor = (Collateral Value * Liquidation Threshold) / Borrowed Value.
• A Health Factor >1 means the position is safe.
• A Health Factor <=1 triggers liquidation. This allows users to monitor their risk exposure continuously. Automated tools watch this factor to initiate liquidation auctions when it drops too low.

LTV represents a fundamental trade-off between capital efficiency and systemic risk.

• High LTV: Allows users to borrow more against their collateral, increasing capital efficiency but raising the risk of under-collateralization during price drops.
• Low LTV: Makes the protocol safer and more resilient to market swings but reduces borrowing power for users. Protocols like Aave and Compound carefully calibrate this balance, often using risk frameworks that assign different LTVs to asset tiers.

A practical example using Aave V3 on Ethereum:

1. Deposit $10,000 worth of WETH as collateral.
2. WETH has a maximum LTV of 80% for this market.
3. This allows you to borrow up to $8,000 in a stablecoin like USDC.
4. The Liquidation Threshold for WETH is 82.5%.
5. Your initial Health Factor is high. If WETH price falls and your borrowed amount reaches ~82.5% of your collateral's value, your position will be liquidated to repay the protocol. This illustrates how LTV governs the entire borrowing lifecycle.

The DeFi LTV concept is adapted from traditional finance, particularly mortgages.

• In a Mortgage: A bank might offer an 80% LTV loan on a $500k house, meaning a $400k mortgage requiring a $100k down payment.
• Key Difference: In TradFi, liquidation is a slow, legal process. In DeFi, it is fully automated and near-instant via smart contracts and keepers when the Health Factor breaks. Understanding this origin highlights DeFi's focus on automating and standardizing credit risk assessment.

A critical distinction is between Maximum LTV (the borrowing limit) and the Liquidation Threshold (the point where liquidation triggers). In protocols like Aave, these are separate values, creating a safety buffer. For example, WETH may have an 82.5% LTV but an 86% Liquidation Threshold. Users can borrow up to 82.5%, but if their collateral value drops such that their debt ratio exceeds 86%, the position becomes eligible for liquidation. This buffer helps prevent instant liquidations from minor price dips.

A loan's Health Factor is a real-time metric derived from its LTV. It represents the safety margin before liquidation. When the collateral value falls or the borrowed value rises, the Health Factor decreases. If it reaches 1.0 (or a protocol-specific threshold like 1.1), the position becomes eligible for liquidation to repay the debt, protecting the protocol from insolvency.

• Example: A position with $150 collateral and $100 debt has an LTV of ~66.7%. If the collateral value drops to $110, the Health Factor nears 1.0, triggering a liquidation event.

LTV calculations depend entirely on price oracles for real-time asset valuation. High volatility in collateral assets (e.g., crypto vs. stablecoins) is a primary risk. A sharp price drop can rapidly push a safe LTV into the liquidation zone before a user can act.

• Oracle Risk: If an oracle provides a stale or manipulated price, it can cause incorrect LTV calculations, leading to unjustified liquidations or, conversely, allowing undercollateralized positions to persist, threatening protocol solvency.

When a position is liquidated, a liquidation penalty (or bonus) is applied. A liquidator repays part or all of the debt in exchange for the collateral at a discounted rate. This penalty is a critical security mechanism that incentivizes liquidators to keep the system solvent and compensates the protocol for the risk.

• Process: The liquidator buys the collateral below market price, sells it, and keeps the difference as profit. The borrower loses their collateral, often incurring a net loss of 5-15% beyond the debt owed.

Users must actively manage LTV to avoid liquidation. Key strategies include:

• Conservative Borrowing: Maintaining a low LTV (e.g., 50% instead of 75%) provides a larger safety buffer against market swings.
• Monitoring Tools: Using dashboards and alerts to track Health Factor in real-time.
• Topping Up Collateral: Adding more collateral or repaying debt to improve the Health Factor during market downturns.
• Understanding Assets: Borrowing against less volatile collateral assets reduces liquidation probability.

Lending protocols set risk parameters that define system-wide safety. These include:

• Maximum LTV: The highest ratio allowed when opening a loan (e.g., 80% for ETH, 65% for other assets).
• Liquidation Threshold: The LTV at which liquidation is triggered (often slightly below the Maximum LTV).
• Liquidation Penalty: The discount rate for liquidators. Governance often controls these parameters, and changes can significantly impact user positions and overall protocol risk.

In DeFi composability, assets borrowed using one protocol (e.g., aETH from Aave) are often used as collateral in another (e.g., to mint a stablecoin). This creates interconnected risk.

• Cascading Liquidations: A price drop in the underlying asset (e.g., ETH) can trigger liquidations across multiple protocols simultaneously, exacerbating market moves.
• Oracle Dependency: Multiple protocols may rely on the same oracle, creating a single point of failure. A user's effective LTV must be considered across their entire DeFi portfolio.

The Collateral Factor is a protocol-specific parameter that determines the maximum Loan-to-Value (LTV) ratio for a given asset. It is expressed as a percentage (e.g., 75%) and acts as a risk ceiling set by the lending protocol's governance.

• Purpose: To limit borrowing power and protect the protocol from undercollateralization during market volatility.
• Example: An ETH collateral factor of 75% means a user can borrow up to $0.75 for every $1 of ETH deposited.
• Dynamic Risk: Factors are adjusted based on an asset's liquidity, volatility, and oracle reliability.

The Liquidation Threshold is the LTV ratio at which a borrower's position becomes eligible for liquidation. It is always higher than the maximum borrow LTV (the collateral factor).

• Mechanism: If a user's LTV rises above this threshold (e.g., 80%), liquidators can repay part of the debt in exchange for the collateral at a discount.
• Buffer Zone: The gap between the max borrow LTV (e.g., 75%) and the liquidation threshold (e.g., 80%) creates a safety buffer for price fluctuations before liquidation occurs.
• Critical Value: This is the most important LTV for a borrower to monitor to avoid being liquidated.

The Health Factor is a numerical representation of the safety of a borrowing position. It is inversely related to LTV.

• Calculation: Health Factor = (Total Collateral Value * Liquidation Threshold) / Total Borrowed Value.
• Interpretation:
  • HF > 1: Position is safe.
  • HF <= 1: Position is undercollateralized and subject to liquidation.
• Dynamic Metric: Fluctuates with the market value of the collateral and borrowed assets. A falling Health Factor warns of approaching liquidation.

Overcollateralization is the fundamental security model of most DeFi lending, where the value of deposited collateral must exceed the value of the loan. LTV is the direct measure of this requirement.

• Principle: A user deposits $150 of ETH to borrow $100 of DAI, resulting in an LTV of ~67%. The extra $50 is the overcollateralization.
• Purpose: This cushion absorbs market volatility, protecting lenders (liquidity providers) from loss if the collateral value drops.
• Contrast: Differs from undercollateralized or uncollateralized lending common in traditional finance.

Liquidation is the process of forcibly closing an undercollateralized loan to ensure protocol solvency. It is triggered when the LTV exceeds the liquidation threshold.

• Process: A liquidator repays part or all of the borrower's debt in exchange for the underlying collateral, typically at a discount (a liquidation penalty).
• Incentive: The discount provides the liquidator's profit and ensures rapid resolution of risky positions.
• Result: The borrower's debt is reduced, but they lose a portion of their collateral. This mechanism is automated and trustless.

A secure Oracle Price Feed is the critical infrastructure that determines the real-time value of collateral and borrowed assets, making LTV calculations possible.

• Dependency: LTV ratios are only as reliable as the oracle data. LTV = (Borrowed Value / Collateral Value), where both values come from oracles.
• Manipulation Risk: Incorrect or manipulated prices can cause faulty LTV calculations, leading to unjustified liquidations or, worse, protocol insolvency.
• Standard Solutions: Protocols use decentralized oracles like Chainlink or create time-weighted average price (TWAP) feeds to mitigate this risk.