Loan-to-Value (LTV) Ratio

Protocols set LTV ratios based on a quantitative and qualitative assessment of risk:

• Asset Volatility: Higher volatility → lower LTV.
• Liquidity Depth: Assets with deep, resilient markets can support higher LTVs.
• Oracle Security & Frequency: Reliable price feeds are critical for safe liquidations.
• Correlation Risk: LTVs are lower for collateral/loan pairs that may de-correlate (e.g., using a volatile altcoin to borrow a stablecoin).
• Liquidation Mechanism Efficiency: Faster, more reliable systems can allow for slightly higher LTVs.

A critical distinction in protocols like Aave is between the Maximum LTV (the borrowing limit) and the Liquidation Threshold (the point of liquidation).

• Maximum LTV: The highest ratio at which you can borrow. Exceeding this is impossible.
• Liquidation Threshold: A higher ratio (e.g., 85% for WETH) at which your position becomes eligible for liquidation. The gap between these values is the Safety Buffer or Liquidation Margin. If your position's LTV rises above the Liquidation Threshold due to price movements, liquidators can repay your debt to seize collateral.

This is the primary determinant of a safe LTV. Highly volatile assets (e.g., memecoins, altcoins) are assigned lower LTV ratios (e.g., 50-65%) to protect against rapid price drops triggering mass liquidations. Stable assets (e.g., ETH, wBTC, stablecoins) can support higher LTVs (e.g., 75-85%). The calculation often uses historical price data and Value at Risk (VaR) models.

An asset's ability to be sold quickly without significant price impact is crucial for liquidations. Assets with deep liquidity on major DEXs (like ETH/USDC pools) allow for safer, more efficient liquidations, supporting a higher LTV. Illiquid assets risk causing bad debt if a liquidator cannot sell the collateral without crashing its price, necessitating a much lower LTV.

LTV enforcement depends entirely on accurate, timely price feeds. Factors considered:

• Oracle Source: Decentralized oracles (e.g., Chainlink) with multiple data providers are preferred.
• Update Frequency: Frequent price updates (e.g., every block) reduce the risk of stale prices allowing undercollateralized positions.
• Manipulation Resistance: Protocols assess an oracle's resilience to flash loan attacks or manipulation, which directly impacts the maximum safe LTV.

This assesses how the collateral asset's price moves relative to the borrowed asset. High correlation allows for higher LTVs. For example, borrowing USDC against USDT collateral (both stablecoins) is low-risk. Borrowing ETH against wBTC collateral is riskier, as both are correlated crypto assets that can crash together, potentially preventing debt repayment. Uncorrelated or inversely correlated asset pairs are the safest.

Each lending protocol has a unique risk appetite set by its governance. Conservative protocols (e.g., Aave, Compound) set lower baseline LTVs and maintain large safety modules (like reserve funds) to cover bad debt. More aggressive or niche protocols might offer higher LTVs to attract users, accepting higher liquidation risks. This is a strategic business decision reflected in the parameter.

The design and incentives of the liquidation process affect the allowable LTV. Key elements:

• Liquidation Bonus: The discount offered to liquidators. A higher bonus can enable a slightly higher LTV by ensuring rapid liquidation.
• Liquidation Threshold vs. LTV: The liquidation threshold is always higher than the LTV, creating a buffer zone. A wider buffer allows for more time for users to act or for liquidators to step in.
• Gas Costs: Efficient, low-gas liquidation mechanisms allow for tighter margins and safer operation at a given LTV.

The Collateral Factor is the maximum Loan-to-Value (LTV) ratio a protocol allows for a specific asset. It is a risk parameter set by governance, representing the percentage of an asset's value that can be borrowed against.

• A 75% collateral factor means you can borrow up to $0.75 for every $1 of collateral.
• Different assets have different factors based on volatility and liquidity (e.g., ETH might be 80%, a newer token might be 50%).
• It directly defines the borrowing limit and acts as the primary safety buffer for the protocol.

The Liquidation Threshold is the LTV ratio at which a borrower's position becomes eligible for liquidation. It is typically set a few percentage points above the maximum borrow limit (Collateral Factor).

• If the threshold is 85%, liquidation can begin once a user's LTV reaches or exceeds 85%.
• This creates a buffer zone between the maximum borrow (e.g., 75%) and the liquidation start point, giving users time to add collateral or repay debt.
• It is a critical parameter for determining the health and safety of a lending pool.

The Health Factor is a real-time, user-specific metric that indicates the safety of a borrowing position. It is calculated as (Total Collateral Value * Liquidation Threshold) / Total Borrowed Value.

• A health factor above 1.0 means the position is safe.
• A health factor at or below 1.0 means the position is under-collateralized and subject to liquidation.
• Users monitor this to avoid liquidation; protocols use it to trigger the liquidation process automatically.

Liquidation is the process of forcibly closing an under-collateralized loan to protect the protocol from bad debt. It occurs when a borrower's Health Factor falls to 1.0 or below.

• A liquidator repays part or all of the borrower's debt in exchange for the borrower's collateral at a discounted rate (liquidation bonus).
• This mechanism ensures the lending pool remains solvent.
• The liquidation penalty or bonus is an incentive for liquidators to participate and cover the protocol's risk.

Overcollateralization is the foundational security model of most DeFi lending, where the value of collateral deposited exceeds the value of the loan taken. The LTV ratio is the inverse measure of this.

• An LTV of 50% means the loan is 200% overcollateralized ($2 collateral for $1 debt).
• This buffer protects against asset volatility, as the collateral value can drop significantly before triggering liquidation.
• It eliminates the need for credit checks but requires users to lock up significant capital.

Maximum LTV is synonymous with the Collateral Factor. It is the highest Loan-to-Value ratio a protocol permits for borrowing against a specific asset. This is the hard ceiling for initial borrowing and the target to stay below for safe position management.

• It is the most important risk parameter for a borrower to know before opening a position.
• Borrowing at the Maximum LTV offers maximum capital efficiency but leaves minimal safety margin against price drops.
• Protocols often publish a weighted average of all asset Maximum LTVs as a key health indicator.