DeFi lending and borrowing: collateral, health factors and liquidation
Lending is the largest genuinely useful part of DeFi and the place where the most people are liquidated by a mechanism they never quite understood.
Why it works without credit checks
A traditional lender assesses whether you will repay. A DeFi protocol cannot: it does not know who you are and cannot pursue you. It solves this by requiring you to deposit more than you borrow.
Deposit 10,000 dollars of Ethereum, borrow up to perhaps 7,000 in stablecoins. If the value of your collateral falls too far, the protocol sells it automatically to repay the loan. No trust and no identity required, which is why it functions at all.
The mechanism, in the order it happens
- You supply collateral into the protocol. It usually earns interest while sitting there, because others are borrowing it.
- Each asset has a maximum loan to value ratio, set by governance according to how volatile and liquid it is. Stablecoins might allow eighty five percent, a volatile token perhaps forty.
- You borrow up to that limit. Interest accrues continuously and is added to the debt.
- The protocol tracks your position against an oracle price feed, block by block.
- If your collateral falls or your debt grows past the liquidation threshold, your position becomes eligible for liquidation.
- Anyone can liquidate you. Bots monitor constantly and are rewarded with a bonus, typically five to ten percent of the amount repaid, taken from your collateral.
The health factor, which is the number that matters
Why anyone borrows against assets they already own
- Liquidity without selling. You need cash and do not want to realise a taxable gain or lose the exposure. The most common legitimate reason.
- Leverage. Borrow stablecoins, buy more of the asset, redeposit. This multiplies both directions and is how most large liquidations happen.
- Yield arbitrage. Borrow at a lower rate than you can safely earn elsewhere. Real, and the spread is usually thin and the risk usually understated.
- Shorting. Borrow an asset, sell it, buy it back cheaper. Less common than perpetuals but structurally cleaner.
- Working capital. Businesses holding crypto treasury borrowing against it to fund operations.
How these positions actually go wrong
Using it sensibly
- Borrow well below the maximum. The limit is not a target; treat sixty percent of it as your ceiling.
- Prefer stable collateral where possible, or accept a much lower ratio for volatile collateral.
- Never borrow to buy more of the same asset you posted as collateral.
- Keep repayment funds available and reachable, not locked in something else.
- Set alerts on the health factor at a level that leaves you time to act, not at the threshold itself.
- Check the position on a schedule so interest drift cannot surprise you.
- Understand the specific protocol's liquidation penalty before you take the loan, since it comes out of your collateral.
BEFORE YOU MOVE ON
Common questions
What is a health factor in DeFi?
A ratio showing how close a borrowed position is to liquidation. Above 2 is comfortable, below 1.1 is dangerous, and below 1 means bots can liquidate you immediately with no notification or grace period.
Why is DeFi lending overcollateralised?
The protocol does not know who you are and cannot pursue you for repayment. Requiring more collateral than the loan, and selling it automatically if it falls, removes the need for trust or identity.
Can I be liquidated without the price moving?
Yes. Interest accrues continuously on the debt, so a position left unattended can drift into liquidation over months with no market move at all.
Risk warning: crypto is highly volatile and largely unregulated. You can lose everything you put in. Nothing here is financial, investment or tax advice.