What Is Crypto Lending?

In brief

• Most major DeFi lending is pool-based and overcollateralized: suppliers provide liquidity, while borrowers pledge more oracle-valued collateral than they initially borrow.
• Loan-to-value (LTV) limits new borrowing. A separate liquidation threshold determines when an existing position can be liquidated.
• Borrow debt grows with interest. Falling collateral, rising debt, a borrowed asset rising in price, or changed protocol parameters can reduce safety.
• Supply and borrow rates are usually variable functions of utilization and governance-set curves, not fixed bank-style coupons.
• Suppliers receive an accounting claim such as an aToken or a positive protocol balance. Redemption still requires functioning contracts and available liquidity.
• Protocols differ. Aave V3 uses multi-asset reserves and health factors; Compound III centers each market on one borrowable base asset; Sky vaults create protocol stablecoin debt against collateral and charge a stability fee.
• “Non-custodial” means the service does not take the user’s private key. It does not mean the deposited assets remain outside protocol contracts or that loss is impossible.

The pool-based lending loop

A simplified lending market has four moving parts.

Suppliers transfer a supported asset into protocol contracts. In Aave V3, the address receives interest-bearing aTokens representing its supplied position. In Compound III, a positive balance of the market’s base asset earns according to the supply-rate model.

Borrowers pledge supported collateral and withdraw a borrowable asset. Their debt increases as interest accrues. They can usually repay at any time, subject to the chain and contract remaining available.

Oracles provide the prices used to value collateral and debt. The protocol does not independently know a dollar price merely because a token trades on-chain.

Liquidators enforce the solvency rules by acting when a position crosses its protocol-defined boundary. The dedicated Liquidation article explains that process and its protocol differences.

There is not always a human lender matched to a named borrower. In a pooled model, suppliers hold a pro-rata claim on shared liquidity while the protocol performs accounting. Peer-to-peer and order-matching designs also exist, but they need not use the same receipt, utilization or liquidation model.

Borrowing power is not the liquidation line

Suppose a protocol values collateral at $10,000, assigns it a 70% maximum LTV and a 75% liquidation threshold.

• At 70% LTV, the account may initially borrow up to $7,000 under that simplified rule.
• The extra gap between 70% and 75% is a safety buffer.
• If debt later reaches $7,500 relative to $10,000 of collateral value, the position reaches the liquidation boundary.

This example explains the concepts, not any live market’s parameters. Real protocols may weight several collateral assets, apply caps, isolation or efficiency modes, set borrowing restrictions, and calculate the boundary at account or market level.

In Aave V3, a common summary is the health factor:

[ \text{health factor} = \frac{\text{collateral value weighted by liquidation thresholds}} {\text{borrowed value}} ]

A value below 1 makes the position eligible for liquidation under the documented V3 model. Health factor can fall because:

• collateral prices decline;
• the borrowed asset rises relative to collateral;
• interest increases outstanding debt;
• collateral is withdrawn or disabled;
• additional debt is taken;
• an oracle update changes the protocol’s recorded values.

LTV answers “how much new debt may this account open?” The liquidation threshold answers “when may existing debt be forcibly closed?” Treating them as the same number erases the intended buffer.

How interest rates move

Pool-based protocols use rates to balance demand for liquidity. A basic utilization measure is:

[ \text{utilization} = \frac{\text{amount borrowed}}{\text{amount supplied}} ]

Exact denominators and treatment of reserves vary. The general incentive is consistent: as more usable liquidity is borrowed, the borrow rate rises to discourage new borrowing, encourage repayment and attract supply.

Aave V3 documents a two-slope curve around an optimal utilization point: borrow rates rise more sharply above that point. Supplier yield comes from borrower interest after the reserve factor, rather than equaling the headline borrow rate.

Compound III separately defines supply and borrow rate curves for its base asset, each with a utilization kink. Interest accrues using a per-second model. Its collateral assets do not earn interest merely because they were posted; only a positive base-asset balance earns the documented supply rate.

Sky vaults are different again. A vault creates stablecoin-denominated debt against a collateral type rather than borrowing a supplier’s matching pool asset. A governance-set stability fee accumulates into vault debt through the protocol’s rate accounting.

Therefore:

• supply APY and borrow APY are not the same;
• rates can change after a position opens;
• an annualized interface number is a projection from current rules, not a guaranteed cash flow;
• token incentives are separate emissions and can disappear or lose value;
• “fixed” or “stable” labels require protocol-specific reading and may not mean fixed for the loan’s entire life.

What suppliers actually own

Supplying is not placing labeled coins in a personal vault. The protocol credits an accounting claim while borrowers may hold the underlying tokens.

In Aave V3, aTokens represent supplied assets and accrue interest through their balance or accounting. Withdrawing burns the claim and returns underlying tokens, but only if sufficient unborrowed liquidity is available. Very high utilization can make a full immediate withdrawal unavailable even though the supplier’s accounting balance still exists.

Compound III illustrates why receipt semantics must be checked by version. In each market, the base asset can be supplied to earn interest, while other supported assets serve as collateral and do not earn the base supply rate. One generic statement that “all deposits earn” would be wrong.

Supplier yield compensates for risks that include:

• borrowers and liquidations failing to keep the pool solvent;
• smart-contract or integration bugs;
• an oracle valuing collateral incorrectly or too slowly;
• a collateral token, wrapper or stablecoin failing;
• utilization reducing exit liquidity;
• admin or governance changes;
• a chain, bridge or sequencer becoming unavailable;
• loss, theft or malicious approval of the receipt token or account.

Audits, reserves, safety modules and supply caps can reduce particular risks. They do not turn the claim into an insured bank deposit.

Oracle risk is credit risk

Overcollateralization only works at the price the protocol uses. If the oracle is stale while collateral is falling, a borrower can remain apparently healthy after the market value no longer covers the debt. If a feed is manipulable or incorrect, healthy accounts may be liquidated or unsafe accounts may borrow too much.

Collateral quality also matters beyond the feed:

• a thin token may have an observable price but too little market depth for liquidation;
• correlated assets can fall together, defeating assumptions based on diversification;
• a wrapped or bridged asset adds issuer, custodian or bridge risk;
• stablecoin collateral and stablecoin debt can move in different directions during a depeg;
• governance may list an asset whose risk changes faster than parameters are updated.

The live Oracles article explains source diversity, update latency, confidence and manipulation in detail. For lending, the practical point is that a precise ratio can still be based on an unsafe price.

Protocol designs are not interchangeable

Aave V3

Aave V3 organizes assets into reserves within pools. Supported supplied assets can earn interest and may be enabled as collateral. Borrowing power and liquidation use per-reserve parameters and an account health factor. Features such as isolation mode and eMode modify what can be combined; they are not universal DeFi concepts.

Compound III

Each Compound III market has one base asset that accounts can supply for interest or borrow. Other listed assets are collateral. Borrow collateral factors and higher liquidation collateral factors create separate initial-borrow and liquidation boundaries. This is materially different from assuming every listed asset sits in one symmetric borrow/lend pool.

Sky vaults

Sky’s vault model lets users create protocol debt against approved collateral. The debt accrues a stability fee, and unsafe vault collateral can be transferred into an auction process. This is a collateralized stablecoin system, not merely an Aave pool with different branding.

Comparisons should name the protocol version and market. Aave V3, Compound v2, Compound III, Maker-era documentation and current Sky documentation do not share one liquidation engine or receipt-token model.

Centralized lending is a different claim

A centralized exchange or lending company may pool customer assets, rehypothecate them and promise an account balance. The user has a direct counterparty claim on the company and may not be able to inspect individual loans or collateral on-chain.

An on-chain protocol replaces some of that company discretion with public code and collateral rules. It introduces different dependencies: contract correctness, oracle feeds, liquidator participation, governance powers, front ends and blockchain execution.

Both can fail. “On-chain” does not mean riskless, and “centralized” is not the only place counterparty-like dependencies exist.

Commonly confused activities

• Native staking: commits assets to a consensus mechanism and may expose them to slashing. It is not borrower interest.
• AMM liquidity provision: supplies trading inventory and creates price-curve exposure such as impermanent loss.
• Yield farming: adds token incentives around a position; the underlying activity may be lending, LPing or something else.
• Flash loans: provide same-transaction liquidity with atomic repayment, not an ordinary open collateralized loan.
• Leveraged looping: repeatedly supplies and borrows to increase exposure. It amplifies rate, oracle, liquidation and execution risk; it is not “extra free yield.”

Questions to ask before supplying or borrowing

1. Which protocol version, chain and market holds the position?
2. Which assets can be borrowed, and which only act as collateral?
3. What are the initial LTV and liquidation threshold, and who can change them?
4. Which oracle feed and update rules value each asset?
5. How are supply and borrow rates calculated, and which incentives are temporary?
6. Is enough unborrowed liquidity available for withdrawal?
7. What happens during liquidation, and who absorbs bad debt?
8. Can contracts be upgraded, paused or capped, and by whom?
9. Does a wrapper, bridge, stablecoin issuer or centralized front end add another dependency?

Those questions describe the position more accurately than a single displayed APY.