Understanding Web3 Lending Models
Overcollateralized Loans
Example: A borrower uses ETH as collateral to borrow DAI. The ETH's value must exceed the DAI's value, allowing the borrower full discretion over the borrowed DAI.
Stablecoin Lending Process
- Collateral Provision: Borrower deposits assets (ETH, BTC, etc.).
- Debt Issuance: Smart contracts generate DAI against the collateral.
- Repayment: Borrower repays DAI to reclaim collateral and close the contract.
Undercollateralized Loans
Enables leveraged positions (>2x). Borrowers may owe more in DAI (debt) than their ETH (collateral) is worth, with assets managed by predefined farming contracts.
APY Under Leverage
Why leverage doesn’t proportionally amplify APY in practice?
Liquidation: The Safety Net of Lending Protocols
Risks of Liquidation
Liquidation safeguards lending protocols by selling collateral at a discount when positions become risky. Key questions:
- What triggers liquidation?
- How are discounts applied?
Traditional Finance vs. DeFi Liquidation
Traditional Finance (Securities Example)
- Trade Matching: Exchange matches buy/sell orders.
- Netting: Calculates net obligations to reduce settlement load.
- Margin Management: Ensures collateral covers positions.
- Settlement: Central clearinghouses finalize asset transfers.
DeFi Liquidation Models
Fixed-Spread Liquidation
- Mechanics: Liquidator repays debt (e.g., DAI) to claim discounted collateral (5–15% typical discount).
Key Parameters:
- Close Factor: 0.5 (50% debt reduction)
- Liquidation Threshold: 0.75 (health factor trigger)
- Spread: 10% (price buffer)
Example:
- Pre-liquidation: 1 ETH = 1,600 DAI; debt = 1,250 DAI.
- Post-liquidation: Borrower repays 625 DAI; lender recovers 0.43 ETH (~687.5 DAI). Health factor improves from 0.96 to 1.095.
Auction-Based Liquidation
Types:
- English Auction: Bids increase over time.
- Dutch Auction: Price declines until a taker emerges.
MakerDAO’s Hybrid Approach:
- Uses flash loans for instant settlement.
- Prices collateral as a time-decaying function.
👉 Explore advanced liquidation strategies
Case Studies & Insights
MakerDAO Bot Failures
Lessons on optimal liquidation strategies:
- Health Factor Dynamics: Fixed spreads don’t always improve health metrics.
- Over-Liquidation: Excessive collateral sales harm borrowers.
- Profit Maximization: Sequential liquidations may yield higher returns.
Flash Loans: A DeFi Innovation
Borrow and repay funds within one atomic transaction, enabled by smart contract pools.
Use Cases
- Arbitrage: Exploit price gaps across platforms.
- Collateral Swaps: Replace collateral without capital outlay.
- Liquidation: Repay debt using borrowed funds to claim collateral.
Example: Liquidate a 2,000 DAI debt position collateralized by 2 ETH via a single transaction.
Key Takeaways
Web3’s lending/clearing mechanisms combine:
- Safety: Overcollateralization and liquidation thresholds.
- Efficiency: Auction models and flash-loan-enabled settlements.
- Innovation: Programmable discounts and time-based pricing.
FAQ Section
Q1: What’s the minimum collateral ratio for overcollateralized loans?
A: Typically 110–150%, varying by protocol.
Q2: How do liquidators profit?
A: By purchasing collateral at a discount (e.g., 10% below market price).
Q3: Can liquidation be avoided?
A: Yes—by adding collateral or repaying debt before health factor breaches the threshold.