Loan Origination

Loan origination in DeFi is executed through smart contracts that automate the terms. A borrower requests a loan by depositing collateral into a protocol. The contract calculates the loan-to-value (LTV) ratio and, if acceptable, mints a loan in the form of a debt token (e.g., aDAI for Compound) or transfers assets from a liquidity pool. This process is permissionless and occurs on-chain.

Borrowers are users who deposit crypto assets as collateral to borrow other assets. Their primary motivations are:

• Leverage: Borrowing to increase trading positions.
• Liquidity Access: Obtaining stablecoins or other tokens without selling appreciated assets.
• Yield Farming: Using borrowed assets to participate in other DeFi protocols for additional yield. They interact directly with protocol front-ends or smart contracts, accepting the risk of liquidation if their collateral value falls below a maintenance threshold.

Lenders supply assets to protocol liquidity pools to earn interest. They are passive participants who deposit assets (e.g., USDC, ETH) and receive a liquid LP token representing their share and accruing yield. Their return comes from:

• Interest payments from borrowers.
• Protocol token incentives (liquidity mining). They bear risks like smart contract vulnerability and impermanent loss in certain pool designs, but are not directly exposed to individual borrower default risk.

These are the automated intermediaries that facilitate origination. Key examples include:

• Aave & Compound: Use pooled liquidity and algorithmically set interest rates.
• MakerDAO: Originates the DAI stablecoin against over-collateralized vaults.
• TrueFi & Maple Finance: Incorporate underwriting for institutional-grade capital pools. The smart contracts enforce all terms, handle oracle price feeds for collateral valuation, and automatically trigger liquidations.

Critical infrastructure participants that ensure the system's integrity.

• Oracles (e.g., Chainlink): Provide real-time price feeds for collateral assets to smart contracts, enabling accurate LTV calculations.
• Keepers / Liquidators: Network participants who monitor positions and execute liquidation transactions when a loan becomes undercollateralized. They are incentivized by a liquidation bonus paid from the borrower's collateral.

An advanced layer introducing credit risk assessment. In protocols like Maple Finance or Aave's Credit Delegation:

• Pool Delegates / Underwriters perform due diligence on institutional borrowers, set terms, and manage pools.
• Lenders delegate their credit line to trusted delegates.
• Borrowers (often institutions) can access under-collateralized or uncollateralized loans based on their creditworthiness, bridging DeFi with traditional finance models.

The core risk in any DeFi loan origination. Flaws in the protocol's smart contracts can lead to catastrophic loss of funds. This includes vulnerabilities like reentrancy attacks, logic errors, or oracle manipulation. Rigorous audits by multiple firms and formal verification are essential mitigations. Examples include the Euler Finance and bZx exploits, where loan logic was exploited.

A primary financial risk for borrowers. If the value of the posted collateral (e.g., ETH) falls relative to the borrowed asset (e.g., stablecoin), the loan may be liquidated. Key factors include:

• Liquidation threshold: The collateral ratio that triggers a sale.
• Liquidation penalty: The fee paid by the borrower.
• Oracle reliability: Accurate, timely price feeds are critical to prevent unfair liquidations or protocol insolvency.

DeFi loans rely on oracles (e.g., Chainlink) for asset pricing. An attacker who can manipulate the price feed can create risk-free profit. For example, temporarily inflating the value of collateral allows borrowing more than is secure, or deflating it triggers unnecessary liquidations. Protocols mitigate this with decentralized oracle networks, time-weighted average prices (TWAP), and circuit breakers.

Many protocols have administrative privileges or are governed by a DAO. Risks include:

• Malicious proposals: A governance attack could pass a proposal to drain funds.
• Admin key compromise: A single private key controlling protocol parameters could be stolen.
• Timelocks: A critical security feature that delays execution of governance decisions, allowing the community to react to malicious proposals.

In peer-to-pool models (e.g., Aave, Compound), lenders face the risk that the entire protocol becomes insolvent if bad debt exceeds reserves. This can happen from mass liquidations during extreme volatility where collateral cannot be sold at the oracle price. Protocols use health factors, safety modules, and insurance funds to buffer against this systemic risk.

Miners/Validators can exploit the public mempool. During loan origination or liquidation, Maximal Extractable Value (MEV) bots can:

• Front-run a user's transaction to take a favorable position.
• Sandwich attack a liquidation, worsening the price for the borrower.
• Back-run profitable opportunities created by the transaction. This increases costs and creates a poor user experience. Solutions include private transaction relays and Flashbots.