DeFi Lending and Borrowing: A Deep Dive into Mechanics, Risks, and Opportunities

Understanding Lending and Borrowing in DeFi

Lending and borrowing are fundamental financial activities that exist in both traditional finance (TradFi) and decentralized finance (DeFi). However, in DeFi, they operate without intermediaries like banks, using smart contracts on blockchain networks to automate processes.

Overview of DeFi Lending and Borrowing

In DeFi, lending and borrowing occur in decentralized protocols where users can:

• Lend assets to earn interest.

• Borrow assets by supplying collateral.

• Earn yields through lending pools and liquidity provisioning.

This is made possible through smart contracts, which enforce rules, manage collateral, calculate interest, and execute liquidations if necessary.

How DeFi Lending Works

Step-by-Step Process

1. Depositing Assets (Supplying Liquidity)

   • Lenders (also called suppliers) deposit assets (e.g., ETH, DAI, USDC) into a lending pool (smart contract).

   • In return, they receive interest-bearing tokens (e.g., aTokens in Aave, cTokens in Compound) representing their deposits.

2. Earning Interest

   • Borrowers pay interest on borrowed funds.

   • Interest earned is distributed to depositors based on supply and demand dynamics.

3. Yield Optimization

   • Some platforms allow lenders to auto-compound their yields through strategies like staking interest-bearing tokens or yield farming.

Example of Lending on Aave

• A user supplies 100 USDC into Aave’s lending pool.

• They receive aUSDC (Aave interest-bearing USDC).

• If the annual lending rate is 5%, after a year, they can withdraw 105 USDC (assuming stable rates).

How DeFi Borrowing Works

Step-by-Step Process

1. Supplying Collateral

   • Borrowers deposit assets (e.g., ETH, BTC, stablecoins) as collateral.

   • The collateral must meet the Loan-to-Value (LTV) ratio requirement.

2. Borrowing Against Collateral

   • Borrowers can take a loan in another asset (e.g., depositing ETH and borrowing USDC).

   • The amount borrowed is limited by the collateral factor (e.g., if ETH has an LTV of 75%, depositing $100 of ETH allows borrowing up to $75 in stablecoins).

3. Accruing Interest

   • Borrowers pay variable or stable interest rates.

   • Interest payments increase the debt over time.

4. Collateral Monitoring

   • If the collateral value drops below the liquidation threshold, liquidation occurs to repay lenders.

   • Borrowers must repay the loan to recover their collateral.

Example of Borrowing on Aave

• A borrower deposits 10 ETH (worth $3,000 per ETH).

• With an LTV of 75%, they can borrow up to $22,500 in USDC.

• If ETH’s price drops and LTV exceeds the liquidation threshold (e.g., 80%), liquidation occurs.

Key Concepts in DeFi Lending & Borrowing

a) Collateralization

• Unlike TradFi, DeFi loans are overcollateralized (borrowers must deposit more than they borrow).

• Example: If the required LTV is 75%, depositing $1000 in ETH allows borrowing $750 in stablecoins.

b) Liquidation

• If collateral value drops below a protocol’s liquidation threshold, liquidators can seize and sell collateral to repay lenders.

• Borrowers can avoid liquidation by adding more collateral or repaying part of the loan.

c) Interest Rate Models

• Variable Rate: Changes based on supply-demand dynamics.

• Stable Rate: Fixed for a set duration (available on some platforms like Aave).

• Dynamic Rates: Some platforms dynamically adjust rates based on utilization.

d) Flash Loans

• Uncollateralized loans executed within a single transaction.

• Used for arbitrage, liquidation, and refinancing.

• Example: Borrow 1M DAI → Use it → Repay within the same transaction.

Popular DeFi Lending Protocols

Risks in DeFi Lending & Borrowing

a) Smart Contract Risks

• Bugs or exploits in smart contracts can lead to asset loss.

• Example: The Cream Finance exploit ($130M loss).

b) Liquidation Risks

• Price volatility can trigger liquidations if collateral value drops.

• Borrowers must monitor LTV ratios closely.

c) Oracle Risks

• DeFi relies on oracles for price feeds.

• Oracle manipulation can cause false liquidations.

d) Interest Rate Risks

• High utilization rates can drive borrowing costs up unexpectedly.