Loan-to-Value (LTV) Ratio

The Loan-to-Value (LTV) Ratio is the primary measure of risk for a collateralized debt position (CDP). It's calculated as (Loan Amount / Collateral Value) * 100%. A lower LTV indicates a safer, more overcollateralized position, while a higher LTV approaches the liquidation threshold, triggering automatic asset seizure to repay the loan.

This is the maximum LTV ratio a protocol allows before a position becomes eligible for liquidation. If market volatility causes the collateral value to drop, increasing the LTV above this threshold, keepers (liquidators) can repay part of the debt in exchange for the collateral at a discount. This mechanism protects the protocol from undercollateralized loans.

• Example: A pool with an 80% LTV limit will liquidate positions if the borrowed amount exceeds 80% of the current collateral value.

The maximum allowed LTV is not uniform; it's a collateral factor assigned per asset based on volatility and liquidity risk. Stablecoins like USDC may have an 85% LTV, while a volatile asset like ETH might be 75%. Protocols like Aave and Compound adjust these factors via governance to manage systemic risk. This creates a risk-tiered borrowing landscape within a single protocol.

The Health Factor is the inverse metric derived from LTV, representing the safety buffer against liquidation. It's calculated as (Collateral Value * Liquidation Threshold) / Borrowed Amount. A health factor above 1.0 is safe; at 1.0, liquidation occurs. Users must monitor this to avoid liquidation, often triggered by collateral depreciation or borrowed asset appreciation.

LTV ratios are a fundamental protocol design parameter. Setting them involves a trade-off:

• Higher LTVs increase capital efficiency and user appeal but raise systemic risk.
• Lower LTVs enhance safety but reduce borrowing power. Protocols use LTV, along with oracle reliability and liquidation incentives, to create a stable lending environment. Sharp adjustments to LTVs are a key risk management tool during market stress.

A user deposits 1 ETH as collateral valued at $3,000. The protocol's LTV ratio for ETH is 75%.

• Maximum Borrowable Amount: $3,000 * 0.75 = $2,250.
• If the user borrows $1,500 of DAI, the initial LTV is ($1,500 / $3,000) * 100% = 50%.
• If ETH's price drops to $2,500, the new LTV becomes ($1,500 / $2,500) * 100% = 60%.
• If the liquidation threshold is 80%, the position remains safe unless ETH falls below $1,875, making the LTV hit 80%.

The primary determinant of LTV. High-volatility assets (e.g., memecoins, altcoins) are assigned lower maximum LTVs (often 50-65%) to protect against rapid price drops triggering liquidations. Low-volatility assets (e.g., stablecoins, staked ETH) can support higher LTVs (up to 90%+). Protocols use oracles to track real-time price feeds and adjust risk models accordingly.

The design of the liquidation engine directly impacts permissible LTV. Protocols with:

• Fast, automated liquidations (e.g., via keeper bots) may allow slightly higher LTVs.
• High liquidation penalties (e.g., 10-15%) act as a buffer, allowing for more aggressive LTVs.
• Grace periods or Dutch auction models are factored into the risk calculation, often resulting in more conservative initial LTV caps.

LTV ratios are set and adjusted by protocol governance or a core risk team. Key parameters include:

• Collateral Factor: The specific LTV cap for each approved asset.
• Debt Ceilings: Maximum borrowable amount per asset, influencing systemic risk.
• Safety Modules & Reserves: Protocols with robust insurance funds or over-collateralized reserves may cautiously permit higher LTVs. Changes often require governance votes.

The liquidity of the collateral asset on decentralized exchanges affects LTV. Illiquid assets pose a liquidation risk; if a large position needs to be sold, it could cause significant slippage and fail to cover the debt. Protocols assess market depth (order book size) and may lower LTVs for assets that cannot be liquidated efficiently without major price impact.

While most DeFi is permissionless, some protocols incorporate on-chain reputation. Factors can include:

• Wallet age and transaction history.
• Historical performance with the protocol (e.g., no prior liquidations).
• Use of identity or credit scoring oracles. Protocols with these features may offer tiered LTVs or better rates to proven users, though this is less common than pure asset-based modeling.

For portfolios with multiple collateral types, LTV is influenced by asset correlation. If all collateral assets are highly correlated (e.g., all DeFi governance tokens), they may crash simultaneously, increasing systemic risk. Protocols using advanced risk engines may lower the aggregate LTV for correlated portfolios or offer higher LTVs for a diversified basket of uncorrelated assets to mitigate this risk.

The Loan-to-Value (LTV) ratio is calculated as (Loan Amount / Collateral Value) * 100%. It quantifies the risk of a position. A lower LTV indicates a larger safety buffer, while a higher LTV brings the position closer to liquidation. Protocols set a Maximum LTV for each asset pair, above which borrowing is not permitted, establishing the initial risk boundary.

The Liquidation Threshold is a higher percentage (e.g., 85%) than the Maximum LTV (e.g., 75%). When a position's LTV exceeds this threshold, it becomes eligible for liquidation. The inverse of this risk is often expressed as a Health Factor: Health Factor = (Collateral Value * Liquidation Threshold) / Loan Value. A Health Factor ≤ 1 triggers liquidation. This two-tiered system (Max LTV for borrowing, Liquidation Threshold for safety) creates a buffer against price volatility.

An LTV ratio is dynamic and its risk profile depends on several factors:

• Collateral Volatility: High-volatility assets (e.g., memecoins) require lower Max LTVs.
• Oracle Reliability: LTV is calculated using price oracles. Inaccurate or manipulated oracle data can cause incorrect LTV calculations and unjust liquidations.
• Asset Correlation: If the borrowed asset and collateral asset are highly correlated (e.g., both ETH and stETH), their prices may fall together, rapidly increasing LTV.
• Liquidity Depth: In a crash, a lack of market liquidity can cause the actual liquidation price to be worse than expected (slippage).

When triggered, a liquidation allows a third party (keeper) to repay part of the delinquent loan in exchange for the collateral at a discounted price. Key risks include:

• Liquidation Penalty: The borrower loses collateral beyond the loan value.
• Bad Debt: If collateral value drops too fast or liquidity vanishes, the protocol may be left with unrecoverable debt.
• Maximizing Capital Efficiency: Users often operate near the Maximum LTV, leaving minimal buffer for normal market fluctuations, increasing liquidation risk.

Protocol governance carefully sets LTV parameters, which are not static. They are adjusted based on:

• Historical volatility data of the collateral asset.
• Overall market conditions (bull/bear markets).
• Asset-specific risks (e.g., smart contract risk of a yield-bearing token).
• Liquidity of the asset on the platform and in general markets. These parameters are critical to the protocol's solvency and are often managed via decentralized governance.

Prudent borrowers must actively manage LTV risk:

• Monitor Health Factor: Use dashboards or alerts to track your position's health.
• Maintain a Buffer: Borrow significantly below the Maximum LTV to absorb price dips.
• Understand the Assets: Know the volatility and correlation of your collateral and borrowed assets.
• Have a Plan for Volatility: Be prepared to add more collateral or repay part of the loan during market downturns to avoid liquidation.

The Liquidation Threshold is the LTV ratio at which a borrower's position becomes eligible for liquidation. It is always set higher than the maximum borrow LTV (the collateral factor), creating a safety buffer. If a user's LTV rises above this threshold due to collateral value dropping or debt value increasing, liquidators can repay part of the debt to seize collateral at a discount.

• Safety Buffer: The gap between the borrow LTV and liquidation threshold prevents instant liquidations from normal price fluctuations.
• Asset-Specific: Like collateral factors, each asset has its own threshold.
• Critical for Borrowers: Defines the "danger zone" for a position.

A user-specific metric that represents the safety of a borrowing position. It is calculated as the weighted value of all collateral divided by the total borrowed value. A Health Factor below 1.0 indicates the position is undercollateralized and subject to liquidation.

• Dynamic Calculation: Updates in real-time with market prices.
• Primary Risk Indicator: Borrowers monitor this to avoid liquidation.
• Formula: Health Factor = (Σ Collateral * Liquidation Threshold) / Total Borrowed

The foundational security model of most DeFi lending, where the value of collateral deposited exceeds the value of the loan taken. The Loan-to-Value (LTV) ratio is the direct measure of this. An 80% LTV means the loan is 80% collateralized, implying 125% overcollateralization.

• Purpose: Mitigates lender risk against asset volatility and default.
• Requirement: Necessary due to the absence of credit checks in permissionless finance.
• Trade-off: Provides security but reduces capital efficiency for borrowers.

The incentive paid to liquidators for resolving undercollateralized positions. When a liquidation is triggered, the liquidator can repay a portion of the bad debt in exchange for the borrower's collateral at a discounted price. This discount is the liquidation bonus.

• Mechanism: For example, a 5% bonus means the liquidator receives $1.05 worth of collateral for every $1.00 of debt repaid.
• System Incentive: Ensures there is always economic motivation to keep the protocol solvent.
• Parameter: Set by governance and varies per collateral asset based on volatility.

Often used interchangeably with Collateral Factor, this is the highest Loan-to-Value ratio at which a user can initially borrow against their collateral. It is the primary risk limit set by a lending protocol.

• Borrow Ceiling: Defines the maximum borrowing power from deposited assets.
• Protocol Design: A core parameter in risk frameworks like Aave's and Compound's.
• Static vs. Dynamic: Usually a static parameter, but advanced models may adjust it based on market conditions.