This article delves into the mechanics of decentralized finance (DeFi) lending, covering collateralized loans, liquidation processes, loan-to-value (LTV) ratios, liquidation factors, and a detailed example of Compound V3's liquidation mechanism.
How DeFi Lending Works
In traditional finance (TradFi), loan defaults allow creditors to seize assets or garnish wages. In DeFi, lenders cannot forcibly extract assets from a borrower's wallet. Instead, borrowers must deposit cryptocurrency collateral exceeding the borrowed amount—a system known as over-collateralization.
Example:
A user deposits $1,000 in ETH to borrow $800 in USDC. Here, ETH acts as collateral, and the $200 buffer ensures lender security.
Motivations for DeFi Borrowing
- Leverage: Users deposit ETH, borrow stablecoins, and reinvest to amplify exposure to asset price movements.
Example: Deposit $1,000 ETH → Borrow $800 USDC → Buy more ETH → Potential higher gains (and risks). - Tax Efficiency: Borrowing stablecoins against crypto collateral may avoid taxable events in some jurisdictions.
- Liquidity Needs: Short-term funding without selling assets (similar to mortgages or car loans in TradFi).
Key Concepts
Collateral Factor
The percentage of collateral value that can be borrowed.
Formula: collateral_factor = (loan_value / collateral_value) × 100%
- Volatile assets (e.g., meme coins) require lower collateral factors (e.g., 50%).
- Stable assets (e.g., BTC, ETH) allow higher factors (e.g., 80–90%).
Loan-to-Value (LTV) Ratio
The current ratio of loan value to collateral value. Fluctuates with:
- Interest accrual on the loan.
- Collateral depreciation.
- Borrowed asset appreciation.
Liquidation Threshold:
- Set above the collateral factor (e.g., 90% vs. 80%) to prevent instant liquidations.
- If LTV exceeds this threshold, the loan is at risk of liquidation.
Liquidation Mechanics
What Triggers Liquidation?
- Interest Accumulation: Loan balance grows over time.
- Collateral Value Drops: Asset prices decline.
- Debt Appreciation: Borrowed asset value spikes (e.g., stablecoin depegging).
Example Scenarios:
- ETH collateral drops from $1,000 to $888 (LTV hits 90%).
- USDC depegs to $1.20, raising debt value to $960 (LTV = 96%).
How Liquidations Work
Compound V3’s Approach:
- Uses idle USDC reserves to repay the loan.
- Protocol absorbs collateral, sells it at a discount via oracle prices.
- Liquidation bots (MEV searchers) profit by buying discounted collateral.
Liquidation Penalties:
- Typically ~10% of collateral value.
- Split between liquidators and the protocol (e.g., 50/50).
Risks and Mitigations
Small Loans
- Low collateral amounts may not cover gas costs, discouraging liquidations.
- Solution: Minimum loan sizes.
Large Loans
- Mass liquidations can cause price slippage, leading to bad debt.
- Solution: Supply caps (e.g., Compound V3’s
supplyCap).
Flash Crashes
- Rapid price drops may outpace liquidation mechanisms.
- Mitigation: Conservative risk parameters (e.g., lower LTV thresholds).
FAQs
1. Why is over-collateralization necessary in DeFi?
DeFi lacks centralized enforcement, so excess collateral ensures lender security.
2. How do protocols set liquidation thresholds?
Risk models (e.g., by firms like Gauntlet) analyze volatility, liquidity, and worst-case scenarios.
3. Can liquidation penalties exceed 10%?
Yes, but higher penalties deter borrowing. Protocols balance safety and competitiveness.
4. What happens if a liquidation fails?
Bad debt accrues, potentially destabilizing the protocol.
5. How can borrowers avoid liquidation?
Monitor LTV ratios, top up collateral, or repay loans during market downturns.
Conclusion
DeFi lending relies on over-collateralization and automated liquidations to maintain solvency. Key takeaways:
- Collateral factors and LTV ratios dictate borrowing limits.
- Liquidations protect lenders but require careful parameter tuning.
- Risks (e.g., flash crashes, bad debt) necessitate robust risk management.
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Originally published December 30, 2023
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