Lending and Borrowing Protocols: Collateral and Liquidation

What you will learn

• How overcollateralised DeFi lending works.
• How to calculate loan-to-value, health factor and liquidation price.
• What happens in a liquidation and what it costs you.
• How variable interest rates depend on utilisation.

Explanation

In DeFi lending protocols (DeFi = decentralised finance), lenders deposit tokens into a pool and earn interest; borrowers deposit collateral and borrow from the pool. There is no credit check, so loans are overcollateralised: you must deposit more value than you borrow. People borrow mainly to get liquidity without selling (which may be a taxable event) or to build leveraged positions.

Key parameters

• Loan-to-value (LTV) = debt ÷ collateral value. The maximum LTV (e.g. 80%) limits how much you can borrow when opening.
• Liquidation threshold (LT): a higher percentage (e.g. 82.5%) at which the position becomes liquidatable.
• Health factor (HF) = (collateral value × LT) ÷ debt. Above 1 is safe; below 1 the position can be liquidated.
• Liquidation price = debt ÷ (collateral amount × LT), for one volatile collateral and a stable debt.

Liquidation

When HF falls below 1, anyone (usually bots called liquidators) can repay part of your debt and receive your collateral at a discount, the liquidation bonus (e.g. 5%). Protocols often limit each liquidation to a share of the debt (commonly up to 50%, depending on protocol and health factor). The bonus is your loss. In fast crashes, several liquidations can happen in a row, and gas spikes can stop you from adding collateral in time.

Oracles

The protocol values collateral using a price oracle. If the oracle reports a wrong price, healthy positions can be liquidated. Oracle design is a core part of protocol risk.

Interest rates and utilisation

Utilisation = borrowed ÷ supplied. Rates are variable and set by a formula: they rise slowly up to an "optimal" utilisation and then very steeply, to attract new deposits and push borrowers to repay. A simplified supply rate:

supply rate ≈ borrow rate × utilisation × (1 − reserve factor)

The reserve factor is the share of interest kept by the protocol. At 100% utilisation, lenders may be unable to withdraw until borrowers repay or new deposits arrive. This is a real liquidity risk for lenders.

Looping

Looping means depositing collateral, borrowing, buying more collateral and depositing again. It multiplies exposure and moves the liquidation price closer. Leverage can lose money quickly; the course "Risk Management" covers leverage in general.

Worked example

Hypothetical example: you deposit 10 ETH at $2,000 = $20,000. Max LTV 80%, LT 82.5%, liquidation bonus 5%. You borrow 10,000 USDC. Interest, gas and taxes are excluded.

1. LTV = $10,000 ÷ $20,000 = 50% (below the 80% maximum).
2. HF = ($20,000 × 0.825) ÷ $10,000 = 1.65.
3. Liquidation price = $10,000 ÷ (10 × 0.825) = $1,212.12. That is a fall of 39.4% from $2,000.
4. ETH drops to $1,200: HF = (10 × $1,200 × 0.825) ÷ $10,000 = 0.99. A liquidator repays 50% of the debt, $5,000.
5. The liquidator receives collateral worth $5,000 × 1.05 = $5,250, i.e. $5,250 ÷ $1,200 = 4.375 ETH.
6. Your cost from the bonus: $250. You now have 5.625 ETH and $5,000 debt.

Interest example: borrow rate 5%, utilisation 80%, reserve factor 10%: supply rate ≈ 5% × 0.8 × 0.9 = 3.6% per year, variable.

Common mistake

Practice activity

On paper: you deposit 5 ETH at $3,000. LT = 80%. You borrow 9,000 USDC. Calculate (a) HF, (b) liquidation price and the percentage fall to reach it, (c) the new HF and liquidation price if you repay 3,000 USDC.

Key takeaways

• HF = (collateral × LT) ÷ debt; below 1 means liquidation.
• Liquidation price = debt ÷ (collateral amount × LT).
• The liquidation bonus is paid by you; crashes and gas spikes make rescue hard.
• Rates follow utilisation; at high utilisation lenders may not be able to withdraw.

Next step

Next, you will learn where staking and other yields really come from and how to judge their risks.