Module 9: DeFi Deep Dive
Lending and Borrowing
Chapter 5 of 14 · about 5 minutes
5.1 Borrowing without a bank
Node had a large ETH holding and needed $15,000 for a home repair. Selling ETH would mean giving up the position, and possibly paying taxes on gains.
"In traditional finance, I'd need a loan application, a credit check, and weeks of waiting," said Node.
"In DeFi, you deposit your ETH as collateral, borrow stablecoins against it, and the money is in your wallet in minutes," said Hash. "No credit check. No application. But also no human to call if ETH crashes. The protocol simply sells your collateral."
5.2 How DeFi lending works
DeFi lending protocols are pools of assets supplied by lenders and borrowed by borrowers, with all rules enforced by smart contracts.
Lenders (suppliers) deposit assets, such as USDC or ETH, into a pool and earn interest. They receive a token or balance representing their deposit plus interest.
Borrowers deposit collateral and borrow other assets from the pool, paying interest.
Because there are no credit checks, DeFi lending is overcollateralised: borrowers must deposit more value than they borrow. If their collateral falls too far, it's liquidated (Chapter 6).
5.3 Collateral parameters
Each collateral asset has risk parameters, set by the protocol's governance or risk managers.
| Parameter | Meaning | Example for ETH |
|---|---|---|
| Maximum loan-to-value (LTV) | The most you can borrow as a percentage of collateral value | 80% |
| Liquidation threshold | The point at which the position becomes eligible for liquidation | 82.5% |
| Liquidation bonus | The discount liquidators receive on collateral they buy | 5% |
| Supply cap and borrow cap | Limits on how much can be supplied or borrowed | Varies |
Riskier or less liquid assets have lower LTVs and higher liquidation bonuses. Some assets can't be used as collateral at all.
5.4 Node's loan
Node deposits 10 ETH at $3,000, worth $30,000, and borrows $15,000 USDC.
| Value | |
|---|---|
| Collateral value | $30,000 |
| Borrowed | $15,000 |
| Current loan-to-value | 50% |
| Maximum LTV | 80% (Node could have borrowed up to $24,000) |
| Liquidation threshold | 82.5% |
Node deliberately borrowed only half of the collateral value, leaving a large buffer. Chapter 6 shows exactly how far ETH can fall before liquidation.
5.5 How interest rates are set
Interest rates in DeFi lending are usually set by formula, based on utilisation: the share of a pool's assets that's currently borrowed (Module 6, Chapter 9).
Utilisation = total borrowed ÷ total supplied
When utilisation is low, rates are low, encouraging borrowing. When utilisation is high, rates rise, encouraging repayment and attracting more lenders. Most protocols use a kinked rate model: rates rise gently up to an optimal utilisation, then sharply above it, to make sure lenders can always withdraw.
Illustrative borrow rate model:
| Utilisation | Borrow rate |
|---|---|
| 0% | 0% |
| 50% | 2.5% |
| 80% (optimal level, the "kink") | 4% |
| 90% | 41.5% |
| 100% | 79% |
Above the kink, rates jump. At 90% utilisation, borrowing costs over ten times what it did at 80%.
Lenders earn a share of what borrowers pay:
Supply rate ≈ borrow rate × utilisation × (1 − reserve factor)
The reserve factor is the share of interest kept by the protocol, often 10% to 20%.
| Utilisation | Borrow rate | Supply rate (10% reserve factor) |
|---|---|---|
| 50% | 2.5% | ~1.1% |
| 80% | 4.0% | ~2.9% |
| 90% | 41.5% | ~33.6% |
"So when lots of people want to borrow, lenders suddenly earn a lot," said Mint.
"And borrowers suddenly pay a lot," said Hash. "Rates in DeFi can change dramatically within hours. Borrowers need to watch them."
Chapter 5 · How lending rates are set
Interest rates rise with the share of a lending pool that is borrowed. Below a kink around 80% utilisation the borrow rate increases slowly; above it the rate rises sharply to discourage further borrowing and protect lenders' ability to withdraw. The supply rate tracks the borrow rate scaled by utilisation.
5.6 Withdrawal risk for lenders
Lenders can withdraw only what isn't currently borrowed. At 100% utilisation, there's nothing left in the pool to withdraw, and lenders must wait for borrowers to repay or for new deposits. The kinked rate model is designed to prevent this by making borrowing very expensive near full utilisation, but during market stress, pools can stay at very high utilisation for periods of time.
| Risk for lenders | Example |
|---|---|
| Withdrawal delays | High utilisation temporarily prevents withdrawals |
| Bad debt | Borrowers' collateral falls too fast to liquidate properly, leaving losses (Chapter 6) |
| Smart contract risk | Bugs or exploits drain the pool |
| Oracle risk | Wrong prices allow over-borrowing (Module 3, Chapter 12) |
| Collateral risk | A poor-quality collateral asset collapses |
5.7 Why people borrow in DeFi
| Reason | Example |
|---|---|
| Liquidity without selling | Node borrows stablecoins against ETH for expenses |
| Leverage | Borrowing stablecoins to buy more ETH, increasing exposure (Chapter 11) |
| Shorting | Borrowing a token and selling it, hoping to buy back cheaper |
| Yield strategies | Borrowing one asset to earn a higher yield elsewhere |
| Tax or timing reasons | Avoiding a sale during a particular period, depending on local rules |
5.8 Variations
Isolated markets. Some protocols create separate lending markets for each pair of collateral and borrowed asset, so problems in one market don't affect others.
Efficiency modes. Some protocols allow higher LTVs for correlated assets, such as borrowing ETH against liquid staking ETH, because their prices move together (Chapter 11).
Fixed-rate lending. Some protocols offer fixed rates for set periods, instead of variable rates.
Undercollateralised lending. A few protocols offer loans to vetted institutions based on reputation or off-chain agreements, which reintroduces credit risk.
5.9 Try it yourself
On a lending protocol's interface, without depositing, find the current utilisation, supply rate, and borrow rate for USDC and ETH. Then find the protocol's interest rate model in its documentation: what is the optimal utilisation (kink), and what happens to rates above it? Finally, find the maximum LTV and liquidation threshold for ETH.
Key takeaways from this chapter
- DeFi lending pools let lenders earn interest and borrowers borrow against collateral, enforced by smart contracts.
- Loans are overcollateralised because there are no credit checks.
- Collateral parameters include maximum LTV, liquidation threshold, and liquidation bonus.
- Interest rates are set by utilisation, often with a kink that makes rates jump above an optimal level.
- Lenders earn a share of borrower interest, minus a reserve factor kept by the protocol.
- Lenders face withdrawal delays, bad debt, smart contract, oracle, and collateral risks.
- People borrow for liquidity, leverage, shorting, and yield strategies; protocols offer variations like isolated markets.