Composable Debt

The core feature where a debt position itself becomes a transferable, interest-bearing asset. This is often represented by an NFT (Non-Fungible Token) or a debt token that encodes the loan's terms, collateral ratio, and health. It enables:

• Secondary Market Trading: Debt positions can be bought, sold, or used as collateral elsewhere.
• Automated Management: Terms can be programmed to auto-liquidate, rebalance, or refinance based on on-chain conditions.

Allows using one debt position as collateral to open another, creating layered financial structures. This enables recursive yield strategies where yields from one protocol can be leveraged to borrow more assets and farm additional yield. Key mechanics include:

• Capital Efficiency: Maximizes the utility of locked capital.
• Risk Stacking: Amplifies both potential returns and liquidation risks, as the health of the entire stack depends on the underlying collateral.

Debt positions are designed to be recognized and utilized across different DeFi applications. A loan originated on a lending protocol like Aave or Compound can be wrapped and used in a yield aggregator or derivatives platform. This is powered by:

• Standardized Interfaces: Such as the ERC-721 standard for position NFTs.
• Money Legos: The principle that one protocol's output can be another's input, creating complex, automated financial pipelines.

Loan terms are not static but can be governed by smart contracts that dynamically adjust based on market data. This includes:

• Dynamic Interest Rates: Rates that change based on utilization or oracle feeds.
• Auto-Liquidation Triggers: Pre-programmed conditions that trigger collateral sales if a health factor threshold is breached, often via keeper networks.
• Loan-to-Value (LTV) Ratios that can be adjusted by governance or market conditions.

Shifts the underwriting model from assessing borrower identity to programmatically assessing collateral quality and position health. This enables permissionless and trust-minimized credit. Features include:

• Overcollateralization: The standard model, where collateral value exceeds loan value.
• Isolated Risk Pools: Limiting contagion by confining specific collateral types to separate vaults.
• On-Chain Credit Scoring: Protocols like Credora provide private credit scores based on wallet history without revealing identity.

Real-world protocols that pioneered or utilize composable debt mechanics:

• MakerDAO: The Vault (CDP) is the original composable debt primitive, minting DAI against locked collateral.
• Euler Finance: Featured risk-adjusted lending pools and permissionless listing with isolated tiered assets.
• Angle Protocol: Uses sanctions lists and oracles to manage stablecoin collateral and debt positions for its agEUR stablecoin.
• Gearbox Protocol: A generalized leverage protocol where users can open Credit Accounts to interact composably with other DeFi apps.

Euler advanced composability through risk-tiered asset segregation. Assets are classified as collateral, cross-collateral, or isolated. This granular control allows protocols and sophisticated users to build complex, leveraged positions with defined risk boundaries.

• Isolated tier assets can only be borrowed, not used as collateral, preventing risky debt loops.
• Cross-tier assets can be both collateral and debt, enabling more complex strategies.
• This architecture allows for the safe creation of composable debt baskets where the risk of one asset doesn't cascade to others, a key feature for structured products and protocol-to-protocol lending.

A primary application of composable debt. A user:

1. Deposits ETH as collateral in a lending protocol (e.g., Aave).
2. Borrows a stablecoin against it (creating a debt position).
3. Swaps the borrowed stablecoin for more ETH and a farmable LP token on a DEX.
4. Deposits the LP token into a yield farm.

This creates a recursive debt position where yield must outpace borrowing costs. The composability of the debt (the stablecoin loan) and the collateral (the LP token position) across multiple protocols is what makes the strategy possible. Automated debt management tools and vaults (like Yearn) abstract this complexity for end-users.

The composability of debt introduces unique systemic risks to the DeFi ecosystem.

• Contagion Risk: The failure of one protocol can cascade through interconnected debt positions across multiple platforms.
• Oracle Risk: The valuation of nested debt collateral is highly dependent on price oracles; manipulation can trigger mass liquidations.
• Regulatory Scrutiny: The transferability and rehypothecation of debt tokens may attract attention from financial regulators.

A debt token is a standardized, transferable ERC-20 token that represents a claim on a user's outstanding loan obligation within a lending protocol. This tokenization is what enables debt composability. Characteristics include:

• Fungibility: Debt tokens can be traded, used as collateral, or integrated into other DeFi applications.
• Interest Accrual: The token's value or redemption rate typically increases over time to reflect accrued interest.
• Examples: Aave's aTokens (interest-bearing) and Compound's cTokens represent a claim on supplied assets, while debt is often represented by variable debt tokens (e.g., variableDebtETH).

Liquidation is the enforced, automated sale of a borrower's collateral when their debt position becomes undercollateralized, protecting lenders from insolvency. It is a critical risk mechanism in composable debt systems. The process involves:

• Health Factor / Collateral Ratio: A metric that triggers liquidation when it falls below a threshold (e.g., below 1.0).
• Liquidation Incentive: A discount (or penalty) offered to liquidators who repay the bad debt and seize the collateral.
• Cascading Risk: In highly composable systems, liquidations in one protocol can trigger liquidations in interconnected positions, creating systemic risk.

A money market protocol is a decentralized application that algorithmically matches lenders and borrowers of crypto assets, creating the primary markets where composable debt originates. These protocols define the terms:

• Interest Rate Models: Algorithms that set borrowing and lending rates based on pool utilization.
• Pool-Based Architecture: Assets are deposited into shared liquidity pools from which loans are drawn.
• Debt Issuance: When a user borrows, the protocol mints a debt obligation against their collateral. Leading examples include Aave, Compound, and Euler Finance.

Cross-margin is a portfolio margining approach where a single pool of collateral backs multiple debt positions across different assets or protocols. It is a sophisticated application of debt composability that increases capital efficiency but also interconnected risk.

• Leverage Building: Users can repeatedly use borrowed assets as collateral to take on new debt, creating leveraged long or short positions.
• Protocol Integration: Platforms like Abracadabra.money (using interest-bearing tokens as collateral) or leveraged yield farming strategies exemplify this.
• Risk Concentration: A price drop in a core asset can simultaneously endanger all linked positions, leading to rapid, multi-protocol liquidations.