An overview of the core principles and mechanisms that enable users to borrow digital assets from decentralized lending platforms.
LABS
How to Borrow Assets from a Lending Protocol
A technical deep dive into the mechanics, risks, and strategic considerations of using decentralized lending protocols to obtain liquidity.
Chainscore © 2025
Foundational Concepts
Collateralization
Collateralization is the process of locking up assets as security to borrow other assets. It protects the protocol from borrower default.
- Users must deposit crypto (like ETH) exceeding the loan value, creating a collateral factor (e.g., 150%).
- If the collateral value drops too close to the loan value, it risks liquidation.
- This mechanism allows for permissionless, trustless loans without credit checks, enabling activities like leveraging positions or accessing liquidity without selling assets.
Loan-to-Value (LTV) Ratio
The Loan-to-Value (LTV) Ratio is a critical risk metric representing the maximum amount you can borrow against your collateral.
- Calculated as (Loan Amount / Collateral Value) x 100. A 60% LTV on $10,000 ETH means a $6,000 max loan.
- Protocols set maximum LTVs per asset; exceeding it triggers liquidation.
- A lower LTV provides a larger safety buffer against market volatility, crucial for managing risk when borrowing stablecoins to farm yield.
Liquidation
Liquidation is an automated process that occurs when a borrower's collateral value falls below a required threshold, protecting the protocol's solvency.
- Triggered when the health factor (a derived metric from LTV) drops below 1 due to collateral depreciation or debt increase.
- Liquidators repay part of the debt at a discount and seize the corresponding collateral, incurring a liquidation penalty for the borrower.
- This mechanism ensures loans remain over-collateralized, maintaining system stability for all users.
Interest Rates
Interest Rates in lending protocols are typically dynamic and algorithmically determined based on supply and demand for each asset.
- Often use a utilization rate model: as more of an asset is borrowed, rates increase to incentivize more suppliers.
- Borrowers might pay variable rates or choose stable rates (if offered) for predictability.
- Understanding rates is key for calculating costs, especially for strategies like leveraged yield farming, where borrowing costs must be less than farming rewards.
Health Factor
The Health Factor is a real-time number indicating the safety of your borrowed position relative to your collateral. It is the primary metric to monitor.
- Calculated as (Collateral Value x Liquidation Threshold) / Total Borrowed. A health factor below 1 risks liquidation.
- It fluctuates with market prices of your collateral and borrowed assets.
- Proactively managing this by adding collateral or repaying debt is essential to avoid involuntary liquidation during market downturns.
Borrowing Assets
The act of borrowing assets involves taking out a loan in one cryptocurrency by using another as collateral, all executed via smart contracts.
- Common use cases include borrowing stablecoins (like DAI) against volatile collateral (like ETH) to spend or invest without triggering a taxable sale.
- Another example is leveraged trading: borrowing more of an asset to amplify a bullish bet on its price.
- This provides flexible access to capital within the DeFi ecosystem, but requires active risk management.
The Borrowing Lifecycle: Step-by-Step
A detailed guide on how to borrow crypto assets from a decentralized lending protocol like Aave or Compound.
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Step 1: Connect Wallet & Choose Market
Prepare your wallet and select the lending pool.
Detailed Instructions
First, you must connect a Web3 wallet like MetaMask to the protocol's interface. Ensure your wallet is on the correct network (e.g., Ethereum Mainnet, Polygon). Navigate to the protocol's borrowing dashboard and select the specific lending market or pool from which you wish to borrow. Each market lists available assets, their current borrowing APY, and collateral factors. For example, you might choose the USDC market on Aave V3 on Polygon.
- Sub-step 1: Click 'Connect Wallet' and authorize the connection in your wallet pop-up.
- Sub-step 2: From the dashboard, select 'Borrow' and browse the list of assets (e.g., USDC, DAI, ETH).
- Sub-step 3: Review key metrics for your chosen asset: liquidity, stable vs variable rate, and health factor implications.
Tip: Always verify the contract address of the interface to avoid phishing sites. The official Aave V3 Polygon market address is
0x794a61358D6845594F94dc1DB02A252b5b4814aD.
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Step 2: Supply Collateral
Deposit assets to secure your loan.
Detailed Instructions
To borrow, you must first supply collateral assets to the protocol. This creates a collateral position that backs your loan and determines your borrowing power. The value of your collateral, adjusted by its Loan-to-Value (LTV) ratio, dictates how much you can borrow. For instance, if you deposit 1 ETH (worth $3,000) with a 75% LTV, you can borrow up to $2,250 worth of other assets.
- Sub-step 1: In the dashboard, navigate to the 'Supply' or 'Deposit' section for your chosen collateral (e.g., WETH).
- Sub-step 2: Enter the amount to deposit and approve the token contract spend allowance if it's your first time.
- Sub-step 3: Confirm the deposit transaction in your wallet. Your supplied balance and updated Health Factor will appear.
Tip: Using volatile assets as collateral is risky. A price drop can trigger liquidation. Consider using stablecoins or diversified assets to reduce risk.
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Step 3: Execute Borrow Transaction
Withdraw the borrowed asset to your wallet.
Detailed Instructions
With collateral supplied, you can now execute the borrow. On the borrowing panel, select the asset you wish to borrow (e.g., USDC). Enter the desired amount, ensuring you stay within your borrow limit to maintain a safe Health Factor (typically >1.5). You must choose an interest rate type: stable rate (predictable) or variable rate (fluctuates with market). Confirm the transaction details, including the borrow APY and any origination fees.
- Sub-step 1: Input the borrow amount. The interface will show your new projected Health Factor.
- Sub-step 2: Select your interest rate mode. For example, on Aave, you might call
borrow(asset, amount, interestRateMode, referralCode, onBehalfOf). - Sub-step 3: Sign the borrow transaction in your wallet. The borrowed assets will be sent directly to your wallet address.
Tip: Borrowing near your maximum limit is dangerous. A small drop in collateral value or a rise in borrowed asset value can quickly make your position undercollateralized.
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Step 4: Monitor & Manage Position
Track your loan health and make repayments.
Detailed Instructions
After borrowing, active management is crucial. Continuously monitor your Health Factor, which is calculated as (Total Collateral Value * LTV) / Total Borrowed Value. If it falls below 1.0, your position may be liquidated. You can manage your position by repaying the borrowed assets (plus accrued interest) or supplying more collateral. Most protocols allow partial or full repayment at any time.
- Sub-step 1: Regularly check your position dashboard for your current Health Factor and accrued interest.
- Sub-step 2: To repay, navigate to the 'Repay' section, approve the token if needed, and confirm the transaction. Use the
repay(asset, amount, rateMode, onBehalfOf)function if interacting directly. - Sub-step 3: To add collateral, simply deposit more assets to boost your Health Factor.
Tip: Set up alerts for your Health Factor using DeFi monitoring tools. Always keep extra funds ready for repayment or adding collateral to avoid liquidation during market volatility.
Protocol Comparison: Aave vs. Compound
How to Borrow Assets from a Lending Protocol
| Feature | Aave | Compound | Key Difference |
|---|---|---|---|
Borrowing Process | Single transaction via 'borrow()' function. Can borrow multiple assets in one transaction. | Separate 'borrow()' transaction required for each asset. | Transaction Efficiency |
Interest Rate Model | Variable and Stable interest rate options for most assets (e.g., USDC, DAI). | Primarily variable rates. Utilizes a utilization-based model with kink points. | Rate Flexibility |
Collateral Requirements | Dynamic Loan-to-Value (LTV) ratios (e.g., ETH: 82.5%, WBTC: 73%). Health Factor must stay >1. | Collateral Factor per asset (e.g., ETH: 82%, WBTC: 70%). Account liquidity must remain positive. | Risk Parameter Naming |
Liquidation Process | Liquidators repay up to 50% of debt in one transaction for a bonus. Health Factor triggers at <1. | Liquidators can repay any amount for a discount (e.g., 5-10%). Liquidation occurs when collateral factor is exceeded. | Incentive Structure & Threshold |
Supported Assets | ~30 assets across multiple networks (Ethereum, Polygon, etc.). Includes stablecoins, altcoins, and LP tokens. | ~15 assets primarily on Ethereum mainnet. Focus on major stablecoins and blue-chip tokens. | Ecosystem Breadth |
Borrow Cap Management | Configurable borrow caps per asset set by governance to limit protocol risk. | Utilizes interest rate model kinks to disincentivize borrowing at high utilization. | Risk Mitigation Approach |
Flash Loan Integration | Native, permissionless flash loans with 0.09% fee. Core feature of the protocol. | Available but less emphasized. Primarily through Comptroller and requires custom integration. | Feature Centrality |
Strategic Considerations
Understanding the Basics
Asset borrowing from a lending protocol like Aave or Compound allows you to use your deposited crypto as collateral to take out a loan in a different asset, without selling your original holdings. This is a core concept of DeFi (Decentralized Finance). You deposit assets into a lending pool and, based on their value and a set collateral factor, you can borrow up to a certain percentage of that value in other supported assets.
Key Points to Consider
- Collateralization Ratio: You must maintain a healthy collateral ratio (e.g., over 150% on Compound) to avoid liquidation, where your collateral is sold to repay the loan.
- Interest Rates: Borrowing rates are typically variable and can change based on supply and demand within the pool. Monitor rates on platforms like Aave to find the best deal.
- Use Cases: Common uses include leveraged trading (borrowing more to increase a position), accessing liquidity without tax events from selling, or yield farming strategies by borrowing one asset to supply another.
Practical Example
When using Aave, you would first deposit ETH into the protocol. The interface will show your borrowing power. You could then borrow stablecoins like DAI against it to spend, while your ETH continues to potentially appreciate. If the value of your ETH collateral falls too close to your loan value, you risk automatic liquidation, so it's crucial to manage your risk.
Critical Risk Factors
An overview of the primary risks users must understand before borrowing assets from a decentralized lending protocol, covering market volatility, technical vulnerabilities, and protocol-specific mechanics.
Liquidation Risk
Liquidation occurs when the value of your collateral falls below the required threshold, triggering an automatic sale to repay the loan.
- A sudden 20% ETH price drop can liquidate a loan collateralized solely with ETH.
- Liquidators are incentivized with a discount, potentially selling your assets at below-market prices.
- This matters as it can result in a total loss of collateral beyond the borrowed amount.
Smart Contract Risk
Smart contract vulnerabilities are bugs or exploits in the protocol's code that can lead to loss of funds.
- A bug in the price oracle could report incorrect asset values, causing faulty liquidations.
- An exploit in the lending pool logic could allow an attacker to drain funds.
- This is critical as decentralized protocols have limited recourse for stolen funds.
Oracle Risk
Oracle failure happens when the external data source providing asset prices becomes inaccurate or manipulative.
- If an oracle is delayed, your collateral might be undervalued during a market spike.
- A malicious actor could manipulate a decentralized oracle to trigger unfair liquidations.
- This matters because your loan's health depends entirely on accurate, real-time price feeds.
Interest Rate Volatility
Variable interest rates can fluctuate based on pool utilization, significantly increasing borrowing costs.
- High demand for a stablecoin loan could cause APY to spike from 5% to 50%+.
- A 'rate hike' can make your loan repayment much more expensive than planned.
- This is crucial for long-term borrowers who may face unpredictable debt accumulation.
Collateral Devaluation
Collateral devaluation is the risk that your deposited assets lose significant market value relative to your debt.
- Borrowing DAI against a volatile altcoin that crashes 60% in a week.
- A protocol-specific token used as collateral could plummet due to governance issues.
- This directly increases your loan-to-value ratio, pushing you closer to liquidation.
Protocol Insolvency
Protocol insolvency occurs when the lending pool lacks sufficient liquidity for users to withdraw their collateral or when bad debt accumulates.
- A mass liquidation event creates more bad debt than the protocol's reserves can cover.
- A bank run scenario where too many users withdraw, freezing remaining funds.
- This matters as it can lead to a total loss of deposited assets, even with a healthy position.
SECTION-TECHNICAL-FAQ
Technical FAQ & Edge Cases
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