Lending Without Trust: How Aave and Compound Work

# Lending Without Trust: How Aave and Compound Work

Traditional lending works because credit scoring, legal contracts, and court systems create accountability. If you don't repay a loan, there are mechanisms to compel repayment — garnishment, asset seizure, credit record damage. On-chain, none of that exists. There's no identity, no credit history, no legal enforcement against a wallet address.

So how do DeFi lending protocols lend billions of dollars worth of assets? The answer is structurally different from traditional credit, and once you understand the core mechanism, a lot of DeFi behavior makes more sense.

## Overcollateralization: Why You Borrow Less Than You Deposit

Aave and Compound require borrowers to deposit more collateral than they borrow. If you want to borrow $1,000 worth of USDC, you might need to deposit $1,500 worth of ETH. The loan-to-value ratio (LTV) varies by asset — volatile assets have lower LTV ceilings; stablecoins have higher ones.

This overcollateralization requirement exists because there's no credit scoring on-chain. The protocol can't assess your creditworthiness, income, or intention to repay. It can only enforce the loan through the collateral it holds. Overcollateralization means that even if you default entirely, the protocol can recover the full loan value from your collateral.

Why would anyone borrow less than they deposit? A few reasons: you get liquidity without selling your assets (no tax event on unrealized gains), you can use stablecoins to enter other positions while keeping ETH exposure, or you're building leveraged positions in complex DeFi strategies.

## Interest Rate Models

DeFi lending protocols use *utilization-based interest rate models*. The basic principle: interest rates rise as more of the deposited capital is borrowed.

If a pool has $10M in USDC deposits and $2M borrowed out, utilization is 20% — rates are low, the pool has plenty of liquidity. If $9M is borrowed, utilization is 90% — rates spike sharply to attract more deposits and incentivize borrowers to repay, preventing the pool from running dry. This is the "kink" in most Aave/Compound rate curves: a gradual slope up to ~80% utilization, then a steep jump to very high rates above that.

This mechanism is self-regulating in normal conditions. In stress conditions — like a market crash where everyone wants to withdraw simultaneously — the high utilization creates a liquidity crunch. Depositors can't withdraw if borrowers haven't repaid, which creates its own problems.

## Liquidations: How Positions Get Closed

Every borrowing position has a *health factor* — the ratio of collateral value (discounted by liquidation threshold) to debt value. If ETH drops and your health factor falls below 1.0, your position is eligible for liquidation.

*Liquidators* are third parties — typically bots — that repay a portion of your debt in exchange for your collateral at a discount (typically 5–15%). This discount is the liquidator's profit, and it's what makes liquidating economically attractive. Liquidators compete to be first — flash loans let them execute liquidations with zero upfront capital by borrowing, liquidating, collecting the discount, and repaying in one atomic transaction.

The liquidation mechanism creates a specific risk during market stress: cascading liquidations. If ETH drops sharply, many positions hit the liquidation threshold simultaneously. Liquidators receive ETH at a discount and typically sell it immediately for stablecoins. That selling pushes ETH price down further, triggering more liquidations. This dynamic played out in March 2020 (ETH -50% in days) and during the May 2021 crash — both times, Aave and Compound protocols survived but users lost significant collateral.

## What This Actually Means for DeFi's Design Space

The overcollateralization requirement means DeFi lending is structurally different from traditional credit. It's capital-inefficient by design — you need to lock up more than you borrow. It excludes anyone who doesn't already have digital assets to post as collateral.

What it enables: fully trustless credit without credit scores, identity, or legal enforcement. A wallet in any country can borrow against ETH collateral at market rates with no questions asked. That's a genuinely different capability — even if the use cases are more limited than they first appear.

The next step in DeFi lending evolution — adding real-world assets as collateral, or building credit scoring through on-chain history — is exactly where the next chapter's subject (yield aggregators and composability) gets complicated. When lending protocols take external collateral, they inherit the trust model of whatever oracle or custodian backs that collateral. Trustlessness begins to have exceptions.

Lending Without Trust: How Aave and Compound Work

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