DeFi Lego: Understanding Lending Protocols (Part 1)

Introduction to Lending Protocols in DeFi

This series explores popular lending protocols across EVM (AAVE, Morpho) and SVM (Marginfi, Solend) ecosystems, highlighting their mechanisms, differences, and high-yield arbitrage opportunities (APY >12%).

Core Concepts

1. Lend (Deposit)

• Users supply assets to liquidity pools, receiving protocol-specific tokens (or none) as proof of deposit.
• Earns interest based on pool utilization rates.
• Dynamic interest rates prevent liquidity shortages.

2. Borrow (Loan)

• Requires collateral deposits first.
• Loan-to-value (LTV) ratios vary by asset (e.g., 75%-100% for stablecoins, 50%-75% for volatile assets).
• Borrowers pay interest and must maintain a healthy Health Factor to avoid liquidation.

3. Withdraw (Redemption)

• Users reclaim deposited assets if liquidity permits.
• May involve burning receipt tokens (if applicable).

4. Repay (Settlement)

• Covers borrowed principal + interest.
• Partial/full repayments unlock collateral.
• Some protocols allow repayment in different tokens (via swaps).

5. Liquidate (Forced Closure)

• Triggered when Health Factor <1.
• Liquidators buy discounted collateral (5%-10% below market price).
• Protects protocol solvency.

6. Flash Loans

• Collateral-free loans repaid within one block.
• Used for arbitrage (DEX price gaps) or liquidation opportunities.

• Example:

  1. Borrow 1,000 USDC via flash loan.
  2. Buy ETH cheaply on DEX-A ($1,980).
  3. Sell ETH at premium on DEX-B ($2,000).
  4. Repay loan + 0.9 USDC fee.
  5. Profit: $19.1.

7. Health Factor

• Formula: (Collateral × LTV) / Borrowed Value.
• Example: $100K BTC (50% LTV) → $50K borrowing capacity → $10K USDT loan → Health Factor = 5.
• Risks: Asset volatility may trigger liquidation at HF <1.

8. Oracles

• Price feeds from Chainlink/Pyth prevent manipulation.
• Critical for loan valuations and liquidation triggers.

9. Interest Models

• Dynamic rates based on utilization:

  • Low usage → lower rates (encourage borrowing).
  • High usage → sharply rising rates (preserve liquidity).
• Depositors earn 50%-70% of borrowing interest.

Real-World Arbitrage Examples

SUI Chain Opportunities

👉 14% USD-denominated APY:

1. Deposit USDC → sUSDC on Scallop.
2. Use sUSDC as collateral to mint Bucket tokens.
3. Stake Bucket for net ~14.5% APY.

👉 20% SUI-denominated APY:

1. Stake SUI → vSUI on NAVI.
2. Borrow SUI against vSUI.
3. Repeat for compounded returns.

FAQ

Q: How do lending protocols mitigate liquidity risks?
A: Through dynamic interest rates that rise sharply when utilization exceeds safe thresholds.

Q: What happens during liquidation?
A: Liquidators repay portions of unhealthy loans at a discount (5%-10%) and keep the collateral.

Q: Are flash loans risky?
A: Yes—failed repayments within the same block revert all transactions, but successful executions enable zero-capital arbitrage.