Borrow Cap

A borrow cap enforces a hard ceiling on the total debt that can be issued against a specific collateral asset. This prevents a single asset from dominating the protocol's debt portfolio and caps the potential bad debt exposure if that asset's price collapses. For example, a pool for a new token might start with a conservative $1M borrow cap.

By limiting borrowing, the cap protects the protocol's overall solvency. It ensures that the total borrowed value (liabilities) does not exceed a manageable multiple of the available liquidity, reducing systemic risk during market stress. This is a key defense against bank runs where many users attempt to withdraw at once.

Borrow caps are not static; governance or risk committees can vote to adjust them based on:

• Asset maturity and historical volatility
• Changes in oracle reliability
• Overall market conditions
• Updates to the protocol's risk models This allows protocols to manage new asset listings cautiously.

Borrow caps work in tandem with collateral factors (Loan-to-Value ratios). While a collateral factor limits how much a single user can borrow against their collateral, the borrow cap limits how much all users combined can borrow of that asset. Both must be satisfied for a borrow transaction to succeed.

Caps prevent a lending pool from being drained of a specific asset, which could lead to extreme borrow APY spikes and failed transactions. They also limit the potential for large, coordinated short positions that could manipulate the price of the underlying asset on other markets.

The cap is enforced in the protocol's core smart contract logic. Before any borrow transaction is finalized, the contract checks if totalBorrows + borrowAmount <= borrowCap. If the cap is reached, subsequent borrow attempts will revert until existing loans are repaid. This check is gas-efficient and critical for security.

The primary purpose is to mitigate systemic risk by preventing over-concentration in a single collateral asset. This protects the protocol from a scenario where a sharp price decline in that asset could trigger widespread, cascading liquidations that exceed the system's capacity to absorb, potentially leading to insolvency.

• Limits exposure to volatile or illiquid assets.
• Prevents liquidity crunches during market stress.
• Acts as a circuit breaker for new borrowing.

Borrow caps directly enforce the fundamental overcollateralization principle of DeFi lending. By capping total debt, the protocol ensures there is always sufficient collateral value in the system to back outstanding loans, even under extreme market conditions. This maintains the health factor of the overall protocol and protects depositors' funds.

Caps are a tool for risk-tiering different assets. New, volatile, or less-liquid assets receive conservative, low caps. Established blue-chip assets like ETH or WBTC may have much higher or no caps. This allows protocols to safely onboard a wider range of assets while quantifying and containing their associated risks.

Borrow caps are not static; they are governance parameters typically controlled by a DAO or core development team. They are adjusted based on:

• Market volatility and liquidity depth.
• Oracle reliability for the asset.
• Historical utilization rates and performance.

This allows for dynamic, data-driven risk management.

A borrow cap works in concert with other risk parameters like the Loan-to-Value (LTV) ratio and liquidation threshold. While LTV controls risk at the individual user level, the borrow cap controls it at the market level. A low LTV but uncapped market could still pose systemic risk from aggregate exposure.

Aave's Isolated Mode provides a clear example. In this mode, new assets are launched with strict borrow caps and can only be used as collateral within their own isolated pool. This contains risk to that specific market, preventing a failure from impacting the protocol's main, uncapped markets like ETH or USDC.

The primary and most direct consequence is that new borrowing of the capped asset becomes impossible. Existing borrowers can still repay debt, but no user can take out a new loan or increase their existing position in that asset. This acts as a circuit breaker to prevent the pool from becoming over-leveraged.

With new borrowing halted, the utilization rate for that asset hits 100%. Since supply yield is generated from borrower interest, the Supply APY for depositors plummets, often to near zero. This removes the incentive to supply more of the asset, protecting liquidity providers from entering an illiquid pool.

A reached borrow cap can paradoxically protect existing borrowers from liquidation in a specific scenario. If the asset's price rises sharply, causing a borrower's health factor to drop, other users cannot borrow the asset to perform a liquidation (as it requires borrowing the asset to sell it). However, direct repayments and liquidations via other mechanisms may still be possible.

Hitting a cap is a clear market signal for governance or protocol administrators. It typically triggers a review process to:

• Increase the cap if demand is organic and safe.
• Adjust interest rate models to naturally curb demand.
• Re-evaluate collateral factors for the asset. This is a key risk management feedback loop.

Many DeFi strategies rely on the continuous availability of borrowing. Reaching a cap can break automated strategies (e.g., leveraged yield farming loops) and cause failures in smart contracts that assume a borrow function will succeed. This can have cascading effects across integrated protocols.

If Aave's borrow cap for USDC is set at $100M and is reached:

• New USDC loans are blocked.
• USDC supply APY drops.
• Governance must vote to raise the cap or adjust rates.
• This historically occurs with new assets or during periods of extreme market demand to manage concentration risk.

The borrow cap is a circuit breaker that prevents a single asset from becoming over-leveraged within a protocol. It mitigates concentration risk and liquidity risk by ensuring the pool retains sufficient reserves to handle withdrawals and liquidations, even during market stress. Without a cap, a surge in borrowing demand for one asset could drain the pool, causing a bank run scenario.

When the total borrowed amount of an asset reaches its hard cap, the protocol's smart contract will reject any new borrow transactions for that asset. Existing borrowers can still repay. This is enforced at the smart contract level, making it a non-negotiable parameter once set. Some protocols implement soft caps with increasing interest rates as a warning signal before the hard cap is hit.

For liquidity providers, a borrow cap protects their deposited assets from being entirely lent out, preserving a liquidity buffer. However, it also caps the potential yield they can earn from borrow interest. If a popular asset hits its cap, LPs may see reduced utilization rates and lower returns, potentially prompting them to reallocate capital to other pools.

Borrow caps are typically set and adjusted by decentralized governance. This introduces parameter risk: a poorly calibrated cap (too low) stifles protocol growth and utility, while a cap set too high fails its risk-mitigation purpose. Malicious or misguided governance actions to alter caps are a key smart contract risk for users to monitor.

Borrow caps work in tandem with collateral factors (Loan-to-Value ratios). A high collateral factor for an asset increases borrowing demand for it, making its borrow cap more likely to be reached. Risk managers must balance these parameters: a volatile asset might have a low collateral factor and a low borrow cap to doubly limit exposure.

Aave V3 uses borrow caps per asset and per network. For example, the borrow cap for USDC on a specific network might be set at $100M. This is visible in the protocol's risk dashboard. When this cap is reached, no further USDC can be borrowed, protecting the protocol's solvency even if all other risk parameters for USDC (like LTV) remain unchanged.