Decentralized Lending Protocol

A decentralized lending protocol is a set of smart contracts on a public blockchain that lets anyone deposit crypto assets to earn interest and anyone else borrow from the pooled deposits by posting collateral. The code sets interest rates, tracks every loan and sells collateral when a loan becomes unsafe, so no company approves borrowers or holds customers' funds. Users include individual traders, funds, DAOs and other DeFi applications that plug into the protocol.

These protocols are the main building block of on-chain crypto lending and a core part of decentralized finance (DeFi). The largest include Aave, Compound, launched in 2018, and Morpho. A related design, the collateralized debt position (CDP) used by MakerDAO (now Sky), mints a new stablecoin such as DAI against collateral instead of lending existing deposits. Protocol settings are usually changed by holders of a governance token.

Imagine a vending machine bank in a public square. People drop coins into a shared pot and get a receipt that slowly grows in value. Anyone who wants to borrow must first lock something more valuable in a glass box on the side of the machine; the machine then lets them take coins from the pot.

The machine keeps checking the value of everything in the glass boxes. If one borrower's locked item becomes worth too little, the machine invites passers-by to repay part of that loan and take the item at a small discount. Nobody runs the machine day to day, but if its design or price display is wrong, its users can lose money.

• Pools and receipt tokens. Each supported asset has a pool. Depositors receive interest-bearing receipt tokens (aTokens on Aave, cTokens on Compound v2) that can be redeemed for the deposit plus interest and can themselves be traded or used elsewhere.
• Collateral factors. Each asset has a maximum loan-to-value for borrowing and a higher liquidation threshold, set by governance according to how volatile and liquid it is.
• Price feeds. Collateral is valued using a blockchain oracle, most often price feeds from Chainlink.
• Interest-rate model. Rates move automatically with how much of the pool is lent out.
• Liquidation. Anyone may repay part of an unsafe loan and receive the borrower's collateral at a discount, the liquidation bonus.

Because positions must always be over-collateralized, the model works without credit checks or identity, which is why it is also called permissionless lending. The same design allows flash loans, which need no collateral because they are repaid within the same transaction.

Rates depend on the utilization rate of a pool:

where $B$ is the total amount borrowed and $D$ is the total deposited. Most protocols use a "kinked" model: the borrow rate rises gently up to an optimal utilization and steeply after it, to attract deposits and discourage borrowing when the pool runs low. Below the kink the borrow rate is:

• $r_0$ is the base rate.
• $U^{*}$ is the optimal utilization (the kink).
• $s_1$ is the rate increase applied between zero and optimal utilization.

Example: a USDC pool has $100 million deposited and $60 million borrowed, so $U = 60 \div 100 = 0.60$. With $r_0 = 0$, $U^{*} = 0.90$ and $s_1 = 4\%$, the borrow rate is $0.60 \div 0.90 \times 4\% \approx 2.67\%$. Depositors earn roughly the borrow rate times utilization, less a reserve share kept by the protocol: $2.67\% \times 0.60 \times (1 - 0.10) \approx 1.44\%$ with a 10% reserve factor.

Aave expresses loan safety as a health factor:

• $C_i$ is the current value of each collateral asset.
• $LT_i$ is that asset's liquidation threshold.
• $D_{\text{total}}$ is the value of all debt, including interest.

A position can be liquidated once the health factor falls below 1. Example: $10,000 of ETH with an 80% threshold backing $6,000 of debt gives $HF = 10000 \times 0.80 \div 6000 \approx 1.33$. If ETH falls 25%, collateral is worth $7,500 and $HF = 7500 \times 0.80 \div 6000 = 1.00$, the edge of liquidation. A liquidator then repays part of the debt and takes collateral worth that amount plus a bonus of, typically, 5–10%. This automatic process is the on-chain form of forced liquidation.

• Smart-contract bugs. Errors in code can let attackers withdraw funds; audits reduce but do not remove this risk.
• Oracle manipulation. If a thinly traded collateral price can be pushed up, an attacker can borrow against inflated collateral. In October 2022 the Mango Markets protocol on Solana lost more than $100 million this way.
• Bad debt. When prices gap down faster than liquidators act, or collateral cannot be sold, the pool is left with loans worth more than their collateral, and depositors bear the shortfall unless a reserve covers it.
• Liquidity crunch. At 100% utilization depositors cannot withdraw until loans are repaid or new deposits arrive, a pool-level version of a bank run.
• Governance and admin risk. Holders of an admin key or a governance majority can change parameters or list risky assets.
• Stablecoin and collateral contagion. Pools rely on stablecoins keeping their peg and on wrapped or liquid staking tokens tracking their underlying assets.

Regulators have not settled how to treat protocols with no operator. The EU's MiCA regulates crypto-asset service providers but does not cover crypto lending, or services provided in a fully decentralized manner, leaving both to later review. US agencies have pursued the people and front-end operators behind protocols rather than the code itself. Some newer pools add identity checks and accept a security token such as a tokenized Treasury fund as collateral. Companies holding stablecoins under blockchain treasury management policies generally cap or forbid deposits into such protocols because of the risks above.

• Aave documentation
• Compound documentation