How DeFi Lending Works
DeFi lending platforms like Aave work by turning over-collateralized borrowing into an automated pool-and-liquidation system.
Contents 6 sections
The cornerstone is that a borrower's collateral must always exceed their borrowed amount to avoid automatic liquidation if their situation sours.
When a borrower's collateral drops below a point of solvency, expressed as a Health Factor, the platform triggers a liquidation process. Where a bank might decide based on risk management, these decisions are entirely automated by the protocol's smart contract.
How borrowing works without credit checks
DeFi lending does not need a credit check, because it relies on the borrower's collateral. Those looking to borrow lock their assets - which must be worth more than what they borrow, upfront and during the loan. A borrower's leverage always starts low and can only reduce as the collaterals fluctuate.
Here's how collateral determines the allowable borrow.
- The borrower's exposure is tracked with a Health Factor, calculated as "Total Collateral Value times the Weighted Average Liquidation Threshold, divided by Total Borrow Value".
- Each collateral asset has a Liquidation Threshold, set by Aave Governance. This determines what Health Factor below 1 triggers a liquidation.
Without credit checks, DeFi lending is performing core banking without a banking license. Yet borrowers are making collateral, not deposits. And there's no insurer.
What makes a position liquidatable
A position may become liquidatable if the collateral value falls - or the borrow position increases - forcing the Health Factor to fall below 1.
- Health Factor below 1. When the Health Factor falls below 1, it signals liquidation, because collateral no longer sufficiently covers the borrowed amount.
- Collateral decrease / Borrow increase. Here's how Health Factor may deteriorate:
- A rise in borrow position, keeping collateral constant
- Weighted Average Liquidation Threshold.8
- Total Borrow Value: 80
- (opening position healthy, as collateral > borrowed leverage)
- Then borrow position increases, to 85
- (collateral still > borrow, but less safe)
- Then borrow position climbs further, to 90
- (now the crucial point, collateral just equals borrow)
- Then borrow position hits 95, unseen by the borrower.
- (collateral safe, but admin would worry)
- Then borrow position leaps another 5, unseen, to 100
- (collateral = borrowed, no surplus, no liquidation in effect)
- But borrow position stops there, and instead - values fall. Collateral has plummeted, but is functioning.
- Weighted Average Liquidation Threshold.8
- Total Borrow Value: 90
- (collateral still = borrowed, no surplus, no liquidation in effect)
- Then collateral Value falls still further, to 85
- (collateral falls further, not enough anymore, a warning)
- Collateral drops to 80, unseen
- (Collateral just matches borrowed, no surplus, no liquidation in effect, but again unhealthy)
- Or finally comes down to 75
- Health Factor: -0.25 (negative, weak)
With collateral functioning as a dynamic floating percentage, but if it just covers the borrowing and no more, the position is liquidated cost-free.
- Health Factor reflects position solvency. The Health Factor is a measure of position solvency that must stay above 1 to avoid liquidation. This effectively means a majority of the borrowed is, at all times, compelled to be collateralized, in practice.
What liquidation actually does
Once liquidation begins, Liquidators aim to re-establish the original percentage between borrow and collateral.
- Debt repayment cap = 50%
- Collectively, this enables fast liquidation without collateral checks at each stage. It's automatic, making it quicker to execute, as liquidations must happen this way.
Collectively, the faster the debt is repaid, the sooner the position can be restored. And savings are gained there the sooner it's settled.
What people use DeFi loans for
Where the model breaks
Public reports suggest the [DeFi model has risks. Bugs and malicious actors are at-work on smart-contracts. Oracles that make price feeds available can fall over. Cascading liquidations may go beyond control. [TO VERIFY: AAA scale]](https://www.coindesk.com/tech/2023/05/14/blockaises-smart-contracts-abuzz-with-decoding-interface-hack-xyz)
Meanwhile, regulators are already
Slide
DeFi has an elegant model: borrowers will remain solvent, at all times. Their loans will never go beyond the collateral, so the borrower must agree to keep in place. Most importantly there they have no credit/risk profile involved.
