How DeFi lending works: collateral, the health factor and liquidations

What is DeFi lending?#

ethereum.org describes two kinds of decentralized borrowing: peer-to-peer, where a borrower borrows from a specific lender, and pool-based, where lenders put funds into a pool that borrowers draw from ^[3]. Aave, the protocol used in the examples below, follows the pool model ^[4]. Instead of checking who you are, the protocol requires the borrower to put up collateral that lenders automatically receive if the loan is not repaid ^[3].

Stablecoins sit at the centre of this market. The US Treasury’s 2021 report noted that stablecoins are frequently “locked” in DeFi to earn interest paid by people borrowing them for leveraged trading or other activities ^[5]. If stablecoins are new to you, start with what are stablecoins.

How does a lending pool work?#

Money flows in a pool-based lending protocol

Suppliers receive a token that tracks their deposit plus interest. ethereum.org’s example: lend 100 Dai to Aave, receive 100 aDai, and watch the aDai balance grow with interest; you can withdraw Dai equal to your aDai balance at any time ^[3]. In practice, a withdrawal also needs enough unborrowed funds left in the pool.

Rates are not fixed by a bank. In ethereum.org’s words, interest rates are “determined by market activity and fluctuate based on real-time supply and demand” ^[6]. In Aave, that link is written into code: the next section shows how.

How does Aave set the interest rate?#

Aave’s rate contract works from one number: utilization, the share of a pool’s money that is currently lent out. In the code it is total debt divided by the funds still available plus total debt ^[2]. The contract’s own description says the model is “based on 2 slopes”: one up to a chosen optimal usage ratio, and another from that point to 100% ^[2].

Suppliers earn less than borrowers pay: in the code, the supply rate is the average borrow rate, multiplied by the share of the pool that is borrowed, and then reduced by a parameter called the reserve factor ^[2]. In plain words: when only half the pool is lent out, only half of the money is earning interest, and that interest is shared by every supplier.

Computed with the formulas above, assuming all debt is at the variable rate. The 4% at 90% utilization echoes an example in Aave’s V3 technical paper ^[4]; Base, Slope2 and the reserve factor here are our own assumptions.

The numbers are not protocol-wide constants: in the Aave V3 core code cited here, the base rate, both slopes and the optimal ratio are passed in when each rate-strategy contract is deployed ^[2], and later Aave versions may handle them differently, and Aave’s technical paper gives an asset whose optimal utilization is 90% only as an example ^[4]. Check the protocol’s page for the asset you use. The arithmetic does show one thing clearly: if Slope2 is set much steeper than Slope1, rates jump once a pool is borrowed past its optimal point.

Why must borrowers lock more than they borrow?#

Because there is no court, credit score or debt collector. If a borrower walks away, the only thing lenders can rely on is the collateral. So every collateral asset has two limits. The loan-to-value (LTV) sets the borrowing power for new loans; the liquidation threshold is the level at which a position counts as undercollateralized and can be liquidated ^[4]. The threshold is set higher than the LTV, and Aave’s paper calls the gap between them “a soft protection for borrowers” ^[4].

What is the health factor?#

The health factor moves every time prices move. If your collateral rises in value, it goes up; if your collateral falls, it goes down ^[1]. Aave says there is no universally “safe” health factor: it depends on how volatile your assets are and how closely collateral and debt move together ^[1].

A 25% fall in ETH is enough to wipe out the buffer. EU supervisors warn that crypto prices can fall and rise quickly over short periods ^[7]; see crypto volatility and risk.

Assumes the debt is a stablecoin whose value does not change and ignores interest that slowly increases the debt.

What happens in a liquidation?#

1. Health factor drops below 1

   Collateral no longer covers the debt with the required margin ^[1].

2. Anyone may act

   Liquidations are permissionless; in practice bots compete to be first ^[1].

3. Liquidator repays debt

   Up to 50% of it while the health factor is above 0.95 and both collateral and debt are at least $2,000; up to 100% at 0.95 or below, or for smaller positions ^[1].

4. Liquidator takes collateral plus a bonus

   An equivalent value of the borrower’s collateral, plus a liquidation bonus ^[1].

The borrower keeps the $6,000 they borrowed but loses $3,150 of collateral to clear $3,000 of debt. Aave’s newer v4 documentation describes liquidation bonuses that follow a Dutch auction, so lower health factors bring higher bonuses ^[8].

ethereum.org compares DeFi liquidations to margin calls in traditional finance and notes that the borrower usually pays a hefty liquidation fee, part of which goes to the liquidator ^[9]. Aave adds that partial liquidations must leave at least $1,000 of both collateral and debt; otherwise the position must be fully cleared ^[1].

Where does the protocol get its prices?#

A smart contract cannot look up prices on the internet. It relies on an oracle, a service that brings outside data on-chain. ethereum.org explains that a lending protocol needs current market prices for deposited collateral to work out how much can be borrowed ^[10]. ethereum.org calls the difficulty of getting correct, up-to-date outside data on-chain the “oracle problem”: data from an oracle must be correct for a smart contract to execute correctly ^[10]. For a lender, a wrong price means a wrong view of every position’s collateral. Aave V3 added protections such as supply and borrow caps to limit risks like oracle manipulation ^[4].

What are E-Mode and other special modes?#

Aave V3 introduced High Efficiency Mode (E-Mode) for assets whose prices move together, such as stablecoins. In the paper’s example, an E-Mode stablecoin category has a 97% LTV, a 98% liquidation threshold and a 2% liquidation bonus ^[4]. Higher limits mean more borrowing power and a thinner buffer: at the maximum 97% loan, the health factor is only about 1.01, so a fall of about 1% in the collateral’s value relative to the debt would reach the liquidation line. Isolation Mode lets governance list an asset as “isolated”: borrowers using it as collateral can borrow only stablecoins approved for this mode, and only up to a set debt ceiling ^[4].

What are the main risks for lenders and borrowers?#

Our general summary of how these risks fall, not taken from a single source. Each protocol’s documentation describes its own safeguards.

What mistakes do beginners make here?#

• Borrowing up to the maximum

  At the maximum LTV, a single-digit percentage fall in collateral can reach the liquidation line. The smaller the loan relative to the collateral, the larger the fall needed before liquidation.

• Watching the price but not the health factor

  Both collateral and debt move. Borrowing a volatile token can push your health factor down even if your collateral holds steady.

• Forgetting interest

  Debt grows over time with interest, slowly lowering the health factor even when prices do not move.

• Assuming you can always withdraw supplied funds

  If most of a pool is borrowed, there may not be enough left for every supplier to withdraw at once.

• Treating the liquidation as the end of the loss

  The liquidation bonus is paid from your collateral, so you lose more than the debt that is repaid.

Frequently asked questions#

The bottom line#

DeFi lending is a machine with simple rules: deposit to earn what borrowers pay, borrow only against collateral, and get liquidated automatically if the health factor drops below 1. The rules are public and enforced by code, which is useful — but they are also unforgiving, and the parameters behind them can change.

To understand the tokens most often borrowed and lent, read how stablecoins keep their peg. To see how analysts measure the money deposited in protocols like these, see total value locked.

Sources#