Lending and Borrowing in DeFi

Loans without banks

If you want a loan from a bank, they check your identity, your income, and your credit score. They need to know you are trustworthy because they are giving you money you do not currently have.

DeFi operates differently. Because wallets are anonymous, trust is impossible. Instead of trust, DeFi uses math and collateral.

If you want to borrow $1,000 on Aave or Compound, you cannot just ask for it. You must first deposit $1,500 worth of crypto as collateral.

Why overcollateralize?

Why borrow $1,000 if you already have $1,500?

1. Keep your exposure: You believe ETH will go up in value. If you sell your ETH for cash, you miss out on the gains. By borrowing against it, you get cash while keeping the ETH.
2. Avoid taxes: In many jurisdictions, selling crypto is a taxable event. Borrowing against it is not.
3. use: You deposit ETH, borrow USDC, buy more ETH, and deposit that. This multiplies your gains (and your losses).

Liquidation

This system has a strict rule: your debt can never exceed the value of your collateral. If it does, the protocol goes bankrupt.

To prevent this, protocols use a Liquidation Threshold. If you deposit $2,000 of ETH and borrow $1,500 USDC, you are safe. But if the market crashes and your ETH is suddenly only worth $1,600, your loan is too risky.

The smart contract will automatically trigger a liquidation. It allows a third party (a liquidation bot) to buy your ETH at a discount to immediately pay off your USDC debt. You lose your ETH, but the protocol stays solvent.

Algorithmic Interest Rates

In DeFi, no central bank sets interest rates. They are determined by utilization (supply and demand).

If a pool has 10 million USDC and borrowers have taken 1 million USDC, the utilization is 10%. There is plenty of supply, so interest rates are low (e.g., 2% APY).

If borrowers take 9 million USDC, utilization is 90%. The pool is almost empty. The algorithm automatically spikes the interest rate (e.g., to 20% APY). This does two things:

1. High rates force borrowers to pay back their loans.
2. High rates entice new lenders to deposit USDC to earn the yield.

The system balances itself purely through economic incentives coded into smart contracts.

Key takeaways

• DeFi lending relies on overcollateralization instead of credit checks.
• If your collateral value drops too low, it is automatically liquidated.
• Interest rates are driven by an algorithm based on pool utilization.
• Lenders earn interest, and borrowers get liquidity without selling their assets.