DeFi: Lending Basics

Explore the fundamentals of DeFi lending: from over-collateralization and LTV ratios to liquidations and leading protocols like Compound and Aave. Discover how blockchain enables peer-to-peer finance without intermediaries.

6 min readFeb 7, 2026

Introduction: A Journey into the Heart of DeFi Lending

Welcome to the borderless, always-open, never-sleeping financial marketplace. This isn’t anything like the bank of old, with its marble counters, bank tellers, and centrally located bank vault. Here, we have the transparent and immutable public ledger known as the blockchain, where all transactions are recorded.

This is the frontier of Decentralized Finance, where lending becomes a direct, peer-to-peer experience.

You can be your own bank, lending out digital assets to earn interest or borrowing against your cryptocurrency. This isn’t based on trust in any single entity, just code.

Want to learn how we arrived at this point from the old world? Check out our Intro to DeFi, as well as the Historical Milestones that made it all possible.”

The Ironclad Pact: The Necessity of Over-Collateralization

Collateralization is a mechanism that ensures the full security and repayment integrity of a loan by requiring borrowers to pledge an asset of greater value than the amount they borrow, thereby creating a protective financial buffer against market volatility and default risk.

In a world without credit checks or central guarantors, how is trust engineered?

The answer is a non-negotiable principle: over-collateralization. This is the fundamental risk management mechanism that secures the entire lending edifice. Imagine you wish to borrow $1,000 worth of a stablecoin. The protocol will not simply take your word for it; it requires you to lock away a digital asset, like Ethereum, valued at $1,500 or more.

This creates a safety buffer, typically 150% or higher, that stands sentinel against the market’s inherent volatility. Should the value of your Ethereum collateral dip, the loan remains secured. This mechanism is vital because, without it, the dramatic price swings common in crypto would lead to catastrophic defaults, exposing lenders to immense risk; a fragility examined in depth in our resource on DeFi Vulnerabilities and Audits.

The Great Trading Posts: Compound and Aave

Two behemoths have risen to dominate this landscape, each with their unique architecture and culture: Compound and Aave.

Compound is an attractive vision of what a market for lending ought to look like. Since its founding in 2018, Compound has been able to automate the process of lending out funds through smart contracts that continually adapt to the market conditions based on the supply and demand of the assets. By depositing funds into the Compound market, users are able to earn cTokens like cETH or cDAI. These are not merely tokens representing ownership, however — they are dynamic assets that earn interest on the user’s behalf over time. Moreover, users are able to earn COMP tokens for participating within the market, which can be used to influence the future direction of the organization. It is a vision of what the future of finance ought to look like: simple, yet profoundly democratic.
Aave is an innovative metropolis that offers users a wide range of features that are unparalleled within the industry. As the evolution of the ETHLend platform, Aave introduced revolutionary concepts like flash loans that can be borrowed and immediately repaid within a single blockchain transaction. Users are able to earn stable or floating interest rates on the assets that they borrow, and the platform is available across a wide range of blockchain “neighborhoods” to reach a wider user base. Users are able to earn interest on the assets that they deposit into the market through aTokens, which earn interest in real-time, and the platform is further secured through a “safety module” that is backed by the community.

Each of these systems is representative of the potential of the decentralized finance industry to offer open, global, and permissionless access to credit. Yet to effectively engage with these systems, one must understand the risks that are inherent within the process, which we delve into further within our analysis of the DeFi Vulnerabilities and Audits.

The Key to the Vault: A Deeper Look at the LTV Ratio

Your borrowing power under this system is precisely quantified by the Loan to Value Ratio, which is a critical metric that determines the maximum amount that can be borrowed against the collateral as a percentage. In the case of a 75% LTV Ratio on the Ethereum deposited, this means that a maximum of $750 can be borrowed for every $1,000 deposited into the system.

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It is noteworthy that this ratio is not constant and is calibrated on a case-by-case basis for different assets. Stablecoins, for instance, enjoy a high LTV Ratio of 80–90%, whereas the LTV Ratio for a speculative altcoin could be as low as 50% or even lower in extreme cases.

The Automated Sentinel: How Liquidations Work

This monitoring finally leads to the most critical event in the DeFi lending system: the liquidation event. When the price of the collateral falls and the health of the loan drops below a certain percentage, as quantified by a collateralization ratio, the loan becomes undercollateralized and is therefore liquidated by the system’s automated monitoring system. In this case, the loan’s collateralization ratio drops below a certain percentage, say 110% for a highly volatile altcoin, and the loan becomes undercollateralized.

To protect the interests of the lenders in the system, the system’s smart contract system now triggers a liquidation event, whereby a professional liquidator, usually a highly advanced bot, is incentivized to pay a portion of the loan amount immediately in exchange for the seized collateral at a discount of 5–10%.

The Orderly Market: Liquidation Incentives

To add efficiency and fairness to this necessary enforcement, some protocols employ auctions. However, Aave utilizes a fixed liquidation bonus model for liquidators, allowing them to receive a percentage bonus on the collateral seized (typically 5–10%), without relying on auctions. Here, the liquidator repays part or all of the debt and receives the collateral plus the bonus, promoting quick and efficient resolutions.

This method aims to achieve better price discovery than a simple fixed discount, potentially recovering more value for the protocol (and leaving the borrower with less debt). Compound employs a fixed liquidation penalty model, where liquidators can absorb collateral minus a penalty, or buy it at a discount if protocol reserves are low. These incentive mechanisms illustrate the sophisticated economic engineering at play, designed to maintain system stability even during stress — a testament to the innovative evolution discussed in DeFi Historical Milestones and Blockchain Basics.

Navigating the Frontier

DeFi lending presents a compelling vista of high potential yields and unprecedented financial sovereignty. Yet it remains a digital frontier rich with opportunity but fraught with risks like smart contract exploits, oracle failures, and extreme volatility.

Prudent exploration demands thorough due diligence, starting with well-audited, time-tested protocols and a clear understanding of the mechanics at play.

For continued guidance on this evolving landscape and the security practices that safeguard it, we invite you to delve deeper into the full archive at Validatus on Medium.

Thank you for reading!

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Note: While we strive to provide the most accurate information, cryptocurrency investments come with inherent risks. Always conduct thorough research before making any investment decisions.