Borrowing on DeFi allows users to gain liquidity without selling the crypto assets, maintaining exposure to potential price appreciation and avoiding capital gains taxes. It enables users to diversify portfolios, leverage positions, or take advantage of yield farming opportunities.
For example, you can use your 1 $ETH as collateral in a lending protocol to borrow stablecoins for a short-term trade. As long as you repay the loan, you'll get your 1 $ETH back, allowing you to benefit from any price increase.
Annual Percentage Yield (APY) is the actual rate of return on an investment over one year, taking into account the effects of compound interest. APY includes interest earned and reinvested. Calculation Formula for APY:
APY=(1−nr)n−1Collateral refers to the assets you pledge or lock up to secure a loan. The collateral is typically worth more than the loan amount to reduce the lender's risk. If you fail to repay the borrowed loan, your collateral can be liquidated to cover the loss.
Utilization rate refers to the percentage of available assets in a lending pool currently being borrowed. Here's the formula:
Utilization=Total SupplyTotal Borrowed×100For example, if a lending pool has 1,000 ETH available for supply and 600 ETH are currently borrowed, the utilization rate would be 60%. Utilization rate helps us to understand how efficiently resources are being used and the level of loan demand.
Health factor is an indicator used in lending &borrowing protocols to show the safety of a collateralized loan. It helps users understand how secure their loan or collateral is relative to its value and liquidation risk.
HealthFactor=Borrowed AmountCollateral Value×Liquidation ThresholdA higher health factor means your loan is safer and less likely to be liquidated. If your health gets below 1, you will have a risk of getting liquidated.
Loan to Value (LTV) in lending and borrowing protocols usually represents the maximum borrowing power of a specific collateral. Different platforms and assets may have different maximum allowable LTV ratios, beyond which your collateral could be at risk of liquidation.
LTV=(Collateral ValueLoan Amount)×100Example: If $ETH collateral has an LTV of 75%, for every 1 ETH worth of collateral, the user will be able to borrow a maximum of 0.75 ETH worth of principal currency.
Liquidation refers to converting collateralized assets into cash or cash equivalents by selling them, often automatically. It occurs when the value of the collateral falls below a certain threshold relative to the borrowed amount.
Example: If you borrow $1,000 in USDC using $1,500 worth of ETH as collateral, and the value of ETH drops so that your collateral is now worth $1,100, the platform might liquidate a portion of your ETH to ensure the loan remains adequately collateralized.
Here's a table summarizing the sources of lending yield in DeFi:
Source of Yield | Description |
Interest Paid by Borrowers | The primary yield source is where borrowers pay interest on their loans. |
Incentives and Rewards | The platform may provide additional tokens or incentives. |
Yield from Collateral Reinvestment | Returns generated by reinvesting collateral in other yield-generating strategies. |
Here's a table summarizing the risks associated with using a lending protocol:
Risk Type | Description |
Platform Risk | The lending protocol may face operational risks like technical failures, governance attacks, etc. |
Smart Contract Risk | Lending protocols run on blockchain smart contracts, which can have bugs or vulnerabilities that hackers might exploit, leading to fund losses. Even with audits, no smart contract is risk-free. |
Liquidation Risk | For Borrowers: In times of market stress, it may be difficult to repay loans or adjust collateral quickly, leading to potential liquidation.
For Lenders: If many users try to withdraw their funds simultaneously, the protocol may experience liquidity issues, making it hard for lenders to retrieve their assets. |
Volatility Risk | For Borrowers: Cryptocurrency collateral is highly volatile, and if its value drops significantly, borrowers risk liquidation and losing their collateral.
For Lenders: If the collateral value falls rapidly and the protocol can't liquidate it in time, lenders may not fully recover their loaned assets. |
Interest Rate Risk | Interest rates on lending protocols can change with supply and demand. Borrowers might face unexpectedly high rates, while lenders could see lower returns if rates fluctuate often. |
Oracle Risk | Lending protocols use price oracles to value collateral. If the Oracle data is wrong or manipulated, it could cause unnecessary liquidations or exploitation. |
Counterparty Risk | Some lending protocols depend on centralized elements or third parties. If these entities fail or act maliciously, it could impact fund security and availability. |
Network Congestion | During periods of high network usage (e.g., on the Ethereum network), transaction delays or high gas fees could prevent timely actions, such as adding more collateral or repaying a loan, increasing the risk of liquidation. |
A collateralized loan is a loan where users use an asset as collateral to borrow other assets. The amount to borrow depends on the value of the collateral provided.
A flash loan in DeFi is an uncollateralized loan that allows users to borrow crypto assets instantly without needing to provide any collateral if the loan is being repaid within the same blockchain transaction.
Aspect | APY | APR |
Definition | Represents the total interest earned on an investment over a year, including compounding interest. | Represents the annualized cost of borrowing or interest earned, excluding compounding. |
Includes Compounding | Yes | No |
Calculation Formula | APY=(1−nr)n−1 | APR=PrincipalInterest Paid or Earned in a Year×100 |
Deposit $1,000 and earn $0.5 today | 20.02% | 18.25% |
The liquidation threshold is a percentage that shows the maximum amount by which the value of the collateral can decrease. If a collateral has a liquidation threshold of 80%, the loan will be liquidated when the debt value is worth 80% of the collateral value.
A liquidation penalty is a fee imposed on the borrower when their collateral is liquidated due to the collateral's value dropping below the required threshold.
For example:
You borrow $500 worth of $P using $1,000 of Ethereum as collateral on a DeFi platform—the liquidation threshold of 80% and a liquidation penalty of 10%. If the value of your collateral Ethereum drops and the value falls below $800 (80% of $1,000), the platform will automatically liquidate your position, and you will be charged an additional 10% penalty on your loan amount, making your total repayment $550.
When your health factor falls, your collateral's value is getting close to the loan amount, putting you at risk of liquidation.
To improve health factor and minimize the risk of liquidation, users can take several steps:
- Add more collateral to increase the security of the loan
- Repay part of the loan to reduce debt
Variable interest rate refers to an interest rate on a loan or deposit that changes based on market conditions or platform-specific algorithms.
For example, the interest rate is 5%, and tomorrow could be charged 6% for the interest rate.
Fixed interest rate refers to an interest rate on a loan or deposit that remains constant throughout the term of the agreement, regardless of changes in market conditions.
For example, the interest rate is 5%, no matter when, you will be charged 5% for the interest rate.
In DeFi, borrowers typically can pay whenever they want as long as the collateral remains above the liquidation threshold. However, interest will be charged on the outstanding loan amount until it is fully repaid. The only exception is flash loans, in which the entire loan must be repaid within the same block.
In DeFi, the asset you pay for interest depends on the platform and the loan terms, but most often, it will be the same asset you borrowed.
It usually has two types, one is rebasing and another one is interest-bearing.
For the rebasing type, the number of tokens in your wallet changes according to the interest earned, like the aTokens(Aave deposit receipt).
For the interest-bearing type, the value of the token increases over time as interest accrues or the protocol might issue more tokens to reflect the earned interest. The number of tokens in your wallet won’t change, like the cToken(Compound deposit receipt).