a bank wants to know who you are.
a pool only wants to know
what you own.
one asks for permission. the other asks for collateral.
it's an autonomous credit market.
smart contracts hold the deposits.
no underwriters. no paperwork. no name.
to settle a loan onchain
same primitive. different rails.
the pool runs 24/7 and never sleeps.
this guide takes it apart —
from the pool to the liquidation.
a lending pool is a balance sheet. assets (loans + cash) always equal liabilities (deposits). util drives both rates.
A lending pool works like a shared savings account that anyone can borrow from. Depositors supply assets — ETH, USDC, whatever the protocol supports — and earn interest. Borrowers draw from the same pool, paying interest for the privilege. The protocol is the intermediary that banks used to be.
Depositors lock assets and receive interest-bearing tokens (aTokens, cTokens). These accrue interest continuously — your balance grows every block. Withdraw anytime, as long as there's available liquidity.
Borrowers draw from the pool, paying interest that flows to depositors. No fixed terms — interest accrues continuously at a variable rate. Repay whenever you want. The only constraint is your collateral.
Available liquidity = total supplied − total borrowed. When this drops toward zero, depositors can't withdraw. This is why interest rates spike at high utilization — the protocol needs to discourage borrowing and incentivize deposits.
Interest rates in DeFi aren't decided by a central bank. They're determined algorithmically by a utilization curve — a function that maps how much of the pool is borrowed to what borrowers must pay. Low utilization, cheap borrowing. High utilization, expensive.
The cliff is the inflection point — typically around 80% utilization. Below it, rates rise gently. Above it, rates spike aggressively. A safety valve: it makes borrowing prohibitively expensive before the pool runs dry.
Depositors earn the supply rate. Always lower than borrow rate — the difference is the protocol's cut. Supply APY = borrow rate × utilization × (1 − reserve factor). Higher utilization, more of your deposits working, higher yield.
Most onchain rates are variable — they change every block based on utilization. Some protocols offer “stable” rates that change less frequently, but these aren't truly fixed. They can still rebalance if conditions shift.
health factor = (collateral × threshold) / debt. drops below 1.00 → liquidator pays your debt and takes your collateral at a discount.
There are no credit scores onchain. No income verification. No legal recourse if a borrower walks away. The only guarantee is the collateral locked in the smart contract — and it must exceed the loan value. Deposit $150 of ETH to borrow $100 of USDC.
LTV = debt / collateral value. Borrow $10K against $15K of ETH and your LTV is 66.7%. Each asset has a max LTV — typically 75–85%. Cross it and you're liquidatable. Volatile assets get lower max LTVs; stablecoins get higher.
Health factor = (collateral × liquidation threshold) / debt. Above 1.0, safe. At 1.0, liquidatable. Further above 1.0, more price movement you can absorb. Experienced borrowers maintain 1.5+ for volatile collateral.
If you already have $150 of ETH, why borrow $100? Because you want to keep your ETH exposure. Selling ETH for USDC means giving up the upside. Borrowing USDC against it lets you use stablecoins while staying long ETH. A leveraged position disguised as a loan.
When your collateral drops in value and your health factor falls below 1.0, your position becomes liquidatable. Anyone — typically an automated bot — can repay part of your debt and seize your collateral at a discount. Borrower loses. Liquidator profits. Protocol stays solvent.
Liquidators receive your collateral at a 5–10% discount to market price. This bonus is the incentive that makes the system work. Without it, no one would run liquidation bots. The bonus is paid by the borrower — out of their collateral.
In a sharp crash, liquidations trigger more selling, which pushes prices lower, which triggers more liquidations. This feedback loop is exactly what happened on Black Thursday (March 2020) when ETH dropped 43% in 24 hours and $8.6M in bad debt hit MakerDAO.
Maintain a buffer. A health factor of 1.05 is one bad candle from zero. 1.5 gives you a 33% cushion against price moves. 2.0+ is conservative. The cost of capital efficiency is risk. Pick your line.
flash loans are atomic. borrow, do anything, repay — all in one transaction. miss the repay, the whole thing reverts.
Flash loans are the most alien concept in DeFi. You can borrow any amount — millions, billions — with zero collateral. The catch: you must repay the entire loan plus a tiny fee within the same transaction. If you don't, the transaction reverts. It never happened. The lender is never at risk.
Flash loans exploit a property unique to blockchains: transaction atomicity. Every step either all succeeds or all fails. The lender faces zero risk — the borrowed funds literally cannot leave the transaction without being repaid. No collateral needed because default is impossible.
Arbitrage between DEXs, liquidations, collateral swaps (switch your loan's collateral in one transaction), and self-liquidation (pay off your own debt using your collateral without first unwinding). Institutional-scale capital for one block — for anyone.
Flash loans also enable exploits. An attacker can borrow millions to manipulate an oracle price, drain a vulnerable protocol, and repay the loan — all in one transaction. The attack costs only gas. This has been the vector for hundreds of millions in DeFi exploits.
old design: one bad token tanks the whole pool. new design: bad debt is contained to that vault.
Early lending protocols — Compound V2, Aave V2 — used monolithic pools. All assets shared a single pool. If one token collapsed, the bad debt spread to everyone. Isolated lending markets flip this: each pair gets its own vault with its own risk parameters. A collapse in one vault cannot contaminate the rest.
In a shared pool, listing a risky asset puts every depositor at risk. In isolated vaults, each market is independent — a risky token/collateral pair only affects the depositors who chose that vault. Risk is opt-in, not systemic. This is the architecture Morpho pioneered on Base.
Isolation means fragmented liquidity. Shared pools let borrowers use any asset as collateral for any loan. Isolated vaults restrict each pair. Capital efficiency drops, but systemic risk drops further. For most markets, the safety is worth more than the efficiency.
Vaults need someone to set the parameters: which collateral, what LTV, which oracle. Curators (humans, DAOs, or risk firms) make these choices and earn a fee on the deposits routed to their vaults. The risk decision is unbundled from the lending protocol itself.
The pool runs 24/7.
The contract never asks your name.
What you collateralize
is up to you.
10 questions. No going back.
Your result is shareable.