Yields & Returns

Borrowing

DeFi Borrowing

Obtaining crypto loans by providing collateral to smart contracts

Definition

Borrowing in DeFi is overcollateralised by construction: there is no credit assessment, so the collateral is the credit. You deposit an asset, the protocol lets you borrow up to a loan-to-value cap set per collateral type, and a smart contract liquidates you automatically if the position drifts past its threshold. Two families dominate. Pooled money markets such as Aave, Compound and Morpho match many lenders to many borrowers and set the interest rate from a utilisation curve, so the rate rises sharply as the pool empties. CDP systems such as Sky (formerly MakerDAO) and Liquity do not borrow anyone's deposit at all: they mint a stablecoin against your collateral and charge either a governance-set rate or a one-off fee. The practical difference is rate volatility: money-market rates move every block, CDP rates move when governance decides.

You deposit more value than you take out, and a contract sells your collateral automatically if its value falls too close to your debt. No credit check, no negotiation, no grace period.

Example

Deposit 10 ETH at $3,000, so $30,000 of collateral. On Aave with an 80% LTV cap you could draw up to $24,000 of USDC, but suppose you take $12,000, a 40% LTV. With a liquidation threshold of 82.5%, you are liquidated when 12,000 equals 10 × price × 0.825, which puts the trigger at an ETH price of roughly $1,454, a 52% drawdown. Draw $20,000 instead and the trigger moves up to about $2,424, a drop of only 19%. The interest is the other half of the equation: at 6% variable on $12,000 you pay $720 a year, and a utilisation spike can take that rate to 15% or more without warning.

How it works

Deposit collateral, borrow up to a per-asset LTV cap, and pay interest set either by pool utilisation on a money market or by governance on a CDP. A health factor tracks how close you are to the liquidation threshold.

Why it matters

It is the base layer for leverage, for stablecoin issuance and for getting liquidity without selling. It is also where most retail DeFi losses happen, because people size against the LTV cap instead of against the drawdown they can survive.

What to check

Compute the collateral price that triggers liquidation, not just your LTV. Check the liquidation penalty, whether the rate is variable or governance-set, which oracle prices your collateral, and whether the protocol has outstanding bad debt.

Risks to Consider

Liquidation carries a penalty on top of the loss, typically 5% to 10% of the liquidated amount
Variable rates follow pool utilisation and can jump from single digits to double digits within hours
The position is priced by an oracle, not by your own view of fair value; a bad print or a thin-market wick can liquidate a healthy position
If a liquidation cannot be executed profitably during a crash, the resulting bad debt is socialised across the protocol's lenders

Common Questions

Why borrow rather than just sell?

Three real reasons. You keep the upside exposure to the collateral. In many jurisdictions a loan is not a disposal, so it does not trigger a taxable event the way selling does. And borrowing is how leverage is built: borrow against an asset, buy more of it, repeat. The cost is that you have converted a price risk you could ignore into a liquidation risk you have to monitor.

How much should I borrow relative to my collateral?

Work backwards from the price that would liquidate you, not from the LTV cap. A 40% LTV on ETH survives roughly a 50% drawdown, which ETH has done more than once. Above 65% LTV on a volatile collateral you are one bad weekend from liquidation. If the collateral and the debt are correlated, such as borrowing a stablecoin against a stablecoin LP, you can safely run much tighter.

What actually happens when I get liquidated?

A liquidator bot repays part or all of your debt and takes the equivalent collateral plus a bonus, which is your penalty. You keep whatever collateral is left and you keep the borrowed funds. It is not a total loss, it is a forced sale at the worst possible moment plus a 5% to 10% haircut. Protocols like Liquity handle it differently, absorbing the position through a stability pool instead of an open auction.