Asset-Backed Lending

A fundamental risk-management principle requiring borrowers to deposit collateral worth more than the loan value. This creates a safety buffer to protect lenders against price volatility. The required ratio is expressed as a Loan-to-Value (LTV) ratio (e.g., 150% collateralization for a 66% LTV loan). If the collateral value falls below a liquidation threshold, the position can be automatically liquidated.

Automated processes that secure the protocol when a borrower's collateral value falls below the required threshold. Key components include:

• Liquidation Threshold: The specific LTV ratio at which a position becomes eligible for liquidation.
• Liquidators: Network participants who repay the outstanding debt in exchange for the discounted collateral, earning a liquidation bonus.
• Auction Models: Some protocols use Dutch auctions or batch auctions to sell collateral, aiming to minimize market impact.

Protocols support specific, whitelisted assets for borrowing and collateral. Collateral assets are typically high-liquidity, established cryptocurrencies like ETH, wBTC, or stablecoins. Debt assets are the tokens a user borrows, often stablecoins like DAI or USDC. The separation allows users to access liquidity without selling their underlying assets, enabling strategies like leveraging long positions or earning yield on idle holdings.

Algorithmic models that dynamically adjust borrowing costs based on pool utilization. Common models include jump-rate and kinked rate models. As the utilization rate of a lending pool increases, borrowing rates typically rise to incentivize repayments and attract more lenders. This creates a market-driven equilibrium for capital supply and demand, distinct from fixed rates in traditional finance.

Key protocol parameters are often managed by decentralized autonomous organization (DAO) governance. Token holders vote on changes to:

• Collateral Factors (LTV ratios) for specific assets.
• Interest Rate Model coefficients.
• Liquidation penalties and thresholds.
• Addition or removal of supported assets. This ensures the protocol can adapt to market conditions and manage systemic risk.

Lenders (or liquidity providers) deposit assets into a lending pool to earn yield. This yield is generated from the interest paid by borrowers. Lenders typically receive a derivative token (e.g., aToken, cToken) that accrues interest in real-time, representing their share of the pool. Yield rates fluctuate based on borrowing demand, providing a passive income stream for supplied capital.

Uncollateralized loans that must be borrowed and repaid within a single blockchain transaction. They enable advanced arbitrage, collateral swapping, and self-liquidation.

• Core Principle: Atomicity—if the loan isn't repaid, the entire transaction reverts, eliminating default risk for the protocol.
• Use Case: An arbitrageur instantly borrows 1M DAI, swaps it for a cheaper stablecoin on another DEX, and repays the loan, pocketing the difference—all in one transaction.

Allows collateral deposited on one blockchain to secure a loan issued on another, facilitated by cross-chain messaging and bridges.

• Process: User locks ETH on Ethereum, a message is relayed to a lending protocol on Avalanche, which then mints a stablecoin loan on Avalanche.
• Benefit: Expands capital efficiency and liquidity access across the multi-chain ecosystem without manually bridging assets.

Large holders (e.g., DAO treasuries, crypto funds) use lending protocols for sophisticated treasury management and leverage.

• Common Strategies: Using stablecoin holdings as collateral to borrow other assets for governance participation (vote-escrow models).
• Example: A DAO collateralizes its USDC to borrow ETH, which it then stakes to earn yield, effectively earning on both the collateral and the borrowed asset.

The primary risk is that the value of the posted collateral falls below the required Loan-to-Value (LTV) ratio, triggering liquidation. High volatility assets (e.g., altcoins) require higher collateralization ratios (e.g., 150%) compared to stable assets (e.g., ETH at 120%). A sharp market downturn can cause cascading liquidations, amplifying sell pressure and creating systemic risk within the protocol.

The automated liquidation mechanism is a critical security component. Risks include:

• Oracle Failure: If the price feed is delayed, manipulated, or fails, liquidations may not trigger or may execute at incorrect prices.
• Liquidation Inefficiency: During high volatility, the liquidation penalty may be insufficient to cover slippage and gas costs, leaving the protocol with bad debt.
• Maximizing Extractable Value (MEV): Liquidations are often targeted by searchers via MEV, which can increase costs for the borrower.

The entire system depends on the security of its underlying smart contracts. This includes:

• Code Vulnerabilities: Bugs in the core lending logic, oracle integration, or upgrade mechanisms.
• Admin Key Risk: Protocols with multi-sig wallets or admin keys controlling critical parameters (e.g., LTV ratios, asset listings) introduce centralization and governance risk.
• Integration Risk: Vulnerabilities in integrated third-party contracts, such as oracle networks or price feed adapters.

Unlike traditional finance, the borrower's identity or creditworthiness is not a factor; risk is purely collateral-based. However, protocol insolvency occurs if the system accrues bad debt (undercollateralized loans that cannot be fully liquidated). This debt is typically socialized across lenders by diluting the value of lending pool shares or using a protocol-owned insurance fund.

When collateral is a wrapped asset (e.g., wBTC, stETH) or a yield-bearing token (e.g., aDAI, cUSDC), additional layers of risk are introduced:

• Bridge Risk: The security of the cross-chain bridge backing the wrapped asset.
• Protocol Dependency: The collateral's value depends on the security of the underlying yield protocol (e.g., Compound, Aave).
• Depeg Risk: For algorithmic or collateralized stablecoins used as collateral.

Price oracles are the most critical external dependency. Attack vectors include:

• Flash Loan Attacks: Borrowing large sums to manipulate the spot price on a DEX that feeds the oracle.
• Data Source Centralization: Reliance on a single price feed or a small set of reporters.
• Time-Lag Exploits: Exploiting the delay between market price movement and oracle price updates. Robust protocols use decentralized oracle networks (e.g., Chainlink) with time-weighted average prices (TWAPs).

Liquidation is the forced closure of an undercollateralized loan position. It occurs when the value of the collateral falls below the protocol's required minimum threshold, protecting lenders from bad debt.

• A liquidation threshold is the specific collateral value at which liquidation is triggered.
• Liquidators repay part of the debt in exchange for the collateral at a discount.
• This mechanism is automated by smart contracts and is fundamental to maintaining protocol solvency.

Overcollateralization is the practice of depositing collateral worth more than the loan value. It is the standard model for permissionless DeFi lending to mitigate the volatility and risk of digital assets.

• Requires borrowers to lock more value than they borrow (e.g., deposit $150 of ETH to borrow $100 of USDC).
• Acts as a buffer against price swings, reducing liquidation risk.
• Contrasts with undercollateralized or uncollateralized lending common in traditional finance.

A Debt Position (or Vault/Collateralized Debt Position - CDP) is a user's specific loan state within a lending protocol. It tracks the borrowed amount, collateral locked, and associated health factor.

• Popularized by MakerDAO's Vault system.
• Each position is isolated and managed by a smart contract.
• Users can manage their position by adding/withdrawing collateral or repaying debt to adjust their risk level.

The Health Factor is a numerical representation of a debt position's safety. It compares the collateral value to the borrowed value, factoring in the liquidation threshold.

• A health factor above 1.0 indicates a safe position.
• A health factor at or below 1.0 risks liquidation.
• It dynamically updates with market prices, giving users a real-time risk metric. Protocols like Aave and Compound use this model.

Stablecoins like USDC, DAI, and USDT are the primary assets borrowed in DeFi lending. Their price stability makes them ideal for loans, as borrowers are not exposed to the volatility of the borrowed asset itself.

• Borrowers often use loans to access liquidity without selling their appreciating collateral (HODL strategy).
• Lenders supply stablecoins to earn interest (yield).
• The stability of the borrowed asset simplifies risk calculations for both parties.