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Lending

DeFi lending protocols (Aave and Compound are the two most widely used) let anyone deposit crypto assets to earn interest, drawn from a pool other users borrow against. This chapter covers the pooled lending model that both protocols share, before the next three chapters cover borrowing, collateral, and liquidations in detail.

The pooled model, not peer-to-peer matching

A DeFi lending protocol doesn't match individual lenders to individual borrowers the way a traditional bilateral loan does. Instead, every depositor's funds for a given asset go into one shared pool, and every borrower of that asset borrows from the same shared pool. A depositor never has a specific counterparty; their claim is on a share of the pool as a whole, and the pool's smart contract tracks exactly how much of it belongs to each depositor.

// Simplified pooled-lending accounting.
interface Pool {
  totalDeposited: number;
  totalBorrowed: number;
}

function utilizationRate(pool: Pool): number {
  return pool.totalBorrowed / pool.totalDeposited;
}

const usdcPool: Pool = { totalDeposited: 10_000_000, totalBorrowed: 6_000_000 };
console.log(utilizationRate(usdcPool)); // 0.6, 60% utilized

Utilization (the fraction of a pool's deposits currently lent out) is the central variable these protocols track, because it directly drives interest rates.

Interest rates set by utilization, not by a central decision

Both the interest rate depositors earn and the rate borrowers pay are computed algorithmically from a pool's current utilization, via a formula set by protocol governance, not decided manually for each loan. As utilization rises toward 100% (a pool with little spare liquidity left to lend), the borrow rate rises sharply, discouraging further borrowing and encouraging new deposits; as utilization falls, rates fall too. This creates a self-correcting mechanism keeping a pool from being fully drained: a rate curve that spikes near full utilization gives borrowers a strong incentive to repay, and depositors a strong incentive to add liquidity, exactly when the pool needs it most.

// A simplified, illustrative version of the kind of kinked rate curve
// Aave and Compound actually use: a gentle slope below a target
// utilization, then a much steeper slope above it.
function borrowRate(utilization: number, kink = 0.8): number {
  const baseRate = 0.02;
  if (utilization <= kink) {
    return baseRate + (utilization / kink) * 0.08; // up to 10% at the kink
  }
  const excessUtilization = (utilization - kink) / (1 - kink);
  return 0.10 + excessUtilization * 0.5; // steep climb toward 60% near 100%
}

console.log(borrowRate(0.6));  // 0.08, moderate rate at 60% utilization
console.log(borrowRate(0.95)); // 0.4749..., much steeper past the 80% kink

Depositor interest is always lower than borrower interest for the same pool; the difference (sometimes going to a protocol reserve, sometimes purely a function of the rate curve's own math) is how these protocols remain solvent, since every dollar paid out to depositors has to come from somewhere.

Why lenders don't need to trust individual borrowers

Unlike a traditional loan, a DeFi lending protocol never performs a credit check or relies on a borrower's identity or reputation at all. Every loan is fully collateralized by crypto assets the borrower has locked in the same protocol (covered fully in Collateral), and an automated liquidation mechanism protects the pool if that collateral's value falls too far. This is what makes pooled, permissionless lending possible at all: the protocol's solvency depends entirely on collateral and code, not on any borrower's willingness or ability to repay based on trust.

Common misconceptions

Depositing into a lending pool is not risk-free just because it's collateralized by other users' assets. The protocol's smart contract code itself carries risk (a bug or exploit, see Smart Contract Auditing), and extreme market conditions can, in rare cases, cause a pool's liquidation mechanism to fail to fully cover a borrower's debt before their collateral value falls below what's owed, leaving depositors exposed to that shortfall.

A DeFi lending protocol's interest rates are not set by a company or committee deciding what's profitable. They're computed directly from the pool's own utilization via a formula, which is why rates can change from block to block as deposits and borrows happen, unlike a bank's periodically-set rate.

Further reading

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