How does DeFi lending work without a bank?

DeFi lending uses smart contracts to match lenders and borrowers automatically. Lenders deposit assets (e.g., USDC) into a protocol pool and earn interest. Borrowers lock up more crypto collateral than they borrow (overcollateralised), then withdraw the loan. Interest rates are algorithmically set based on supply and demand in each pool — no credit checks, no bank approval, no human intermediary. Protocols like Aave, Compound, and MakerDAO operate this way 24/7.

What is liquidation risk in DeFi borrowing?

Liquidation occurs when your collateral value drops below the protocol's minimum collateralisation ratio. For example, if Aave requires 130% collateral and your ETH collateral falls to that level due to price drops, a liquidator can repay part of your loan and claim your collateral at a discount (the liquidation penalty). To avoid liquidation: maintain a high collateral ratio buffer (150%+), monitor positions during volatile markets, and set alerts when collateral ratio approaches danger levels.

Why would someone borrow crypto on DeFi instead of selling it?

Borrowing against crypto instead of selling preserves your position — you keep exposure to potential price appreciation while accessing liquidity. This is also a tax strategy in some jurisdictions: selling crypto triggers a taxable capital gains event, while borrowing against it does not (consult a tax professional for your jurisdiction). Common use cases include: borrowing stablecoins to fund Polymarket positions, paying expenses without selling BTC, or accessing liquidity for business operations while holding long-term crypto positions.

DeFi · Intermediate

DeFi Lending & Borrowing: Aave, Compound & MakerDAO Explained

April 25, 20268 min readpoly-sim.com

DeFi lending protocols let you earn interest on idle crypto or borrow against your holdings without selling — no bank approval, no credit check. The largest protocols (Aave, Compound, MakerDAO) have processed hundreds of billions in loans since 2019. But liquidation risk is real and can wipe out your collateral if markets move against you.

How DeFi Lending Works

Lending protocols use liquidity pools: depositors add assets, borrowers take assets, and interest rates are set algorithmically based on utilisation rate (the percentage of the pool that's been borrowed). When utilisation is high, rates rise to attract more depositors. When low, rates fall to incentivise borrowing.

The Three Major Protocols

Aave

The largest DeFi lending protocol by TVL. Supports 20+ assets including ETH, BTC (wrapped), USDC, USDT, DAI. Key features: flash loans (uncollateralised loans repaid in one transaction), rate switching (stable vs variable), and credit delegation. Available on Ethereum mainnet and multiple L2s.

Compound

The protocol that pioneered yield farming with COMP token distribution. Simpler interface than Aave, slightly fewer assets. Known for algorithmic interest rates and cTokens (interest-bearing representations of your deposits).

MakerDAO

Different model: not a pool-based lender but a collateralised debt position (CDP) system. Deposit ETH or WBTC as collateral, mint DAI stablecoin against it at a minimum 150% collateralisation ratio. You're essentially borrowing your own DAI, with ETH as backing.

Liquidation Risk: The Critical Warning

If your collateral value falls below the liquidation threshold (typically 75-82.5% of borrowed amount on Aave), bots automatically liquidate a portion of your collateral to repay the debt. Liquidation happens at a penalty (typically 5-10% discount for the liquidator).

🚨 Liquidation Example

You deposit 1 ETH ($3,000) and borrow $1,500 USDC (50% LTV). ETH falls to $1,800. Your LTV is now 83.3%, triggering liquidation. The protocol sells your ETH at a 8% discount ($1,656), repays the loan, and you receive the remainder — often very little. Always maintain significant buffer above the liquidation threshold, especially with volatile collateral.

How Interest Rates Work in DeFi Lending

Unlike banks, DeFi interest rates are set algorithmically based on utilisation rate — the percentage of a lending pool that has been borrowed:

Low utilisation (0–80%): Rates are low to attract more borrowers and put deposited capital to work
High utilisation (80–100%): Rates spike sharply to incentivise more depositors and discourage additional borrowing
Optimal utilisation target: Protocols like Aave v3 target ~80–90% utilisation — above this, the interest rate curve "kinks" upward steeply to push utilisation back down

This means DeFi lending rates are volatile and change with market conditions. USDC lending rates can range from 2% APY in quiet markets to 20%+ during high-demand periods (DeFi bull runs when everyone wants to borrow stablecoins for leveraged positions).

Choosing the Right Protocol for Your Goal

Different lending protocols suit different users and use cases:

Aave v3: Best for lenders — largest TVL, most assets supported, most audits, E-Mode for capital efficiency between correlated assets (e.g., stETH/ETH). Widely considered the safest blue-chip lending protocol.
Compound v3: Simplified architecture around USDC as the core borrowable asset. Lower complexity = smaller attack surface. Good choice for conservative USDC lenders.
MakerDAO / Spark: Best if you want to mint DAI stablecoin against ETH, WBTC, or stETH collateral. Higher minimum collateralisation (150%+) but no liquidation by external bots — you self-manage your CDP through the Maker dashboard.
Morpho: P2P lending layer on top of Aave/Compound — matches lenders and borrowers directly for better rates when matched, falling back to Aave/Compound rates when not. Can achieve 10–30% better yields than depositing directly.

Advanced Strategy: Recursive Borrowing (Loop)

A common DeFi strategy for amplifying staking yields:

Deposit stETH on Aave as collateral
Borrow ETH against it (at ~75% LTV)
Stake the borrowed ETH to get more stETH
Deposit the new stETH as additional collateral
Repeat 3–4 times

This leverages the spread between staking yield (~4% APY) and borrowing cost (~2% APY), producing 3–4× leveraged staking returns (~6–8% net APY) on the original capital. Risk: if ETH price crashes, all positions get closer to liquidation simultaneously. The 2022 LUNA crash showed how quickly this can cascade in correlated downturns.

💡 DeFi Lending for Polymarket Traders

USDC sitting in your Polymarket wallet earns 0%. Deploy idle capital to Aave on Polygon — the same chain Polymarket uses. Earn 4–8% APY on your USDC while waiting for attractive prediction market opportunities, then withdraw to Polymarket within minutes when you want to trade. Use the Compound Interest Calculator to see how this idle yield accumulates over months.

Collateral Types and Risk Tiers

Not all collateral is treated equally. Aave v3 uses a tiered risk system:

Tier 1 (High LTV — 80%+): ETH, stETH, WBTC, USDC — major assets with deep liquidity and high market cap. Lower liquidation risk from price manipulation.
Tier 2 (Medium LTV — 65–80%): Mid-cap assets like LINK, AAVE token, SNX. More volatile, lower maximum borrow amounts.
Isolation Mode: New or riskier assets can only be deposited in isolation — you can't combine them with other collateral. Borrowing capacity capped at a fixed dollar amount.
E-Mode (Efficiency Mode): For correlated assets (e.g., stETH and ETH), allows up to 95% LTV — much higher efficiency when borrowing the same underlying asset you're collateralising with.

Always check the specific LTV and liquidation threshold for your collateral on the Aave app before borrowing. The numbers change with governance votes as risk parameters are updated.

← DeFi Wallets DeFi Security → All DeFi Articles