Lending Markets from First Principles

What you'll learn

• What an On-Chain Money Market Actually Is
• Interest-Rate Models: The Utilization Curve
• Collateral Factors, LTV, and Liquidation Thresholds
• Aave and Compound: Concrete Comparisons
• Bad Debt and Why It Happens
• What to Remember

Key terms

Money market

An on-chain protocol where pooled liquidity is supplied by lenders and borrowed against by users posting overcollateralized assets, with interest rates set algorithmically by utilization.

Utilization

The fraction of supplied assets currently borrowed (total borrows / total supply). It is the input to a money market's interest-rate model.

Kinked interest-rate model

An interest-rate curve with a gentle slope below a target utilization point and a steep slope above it, designed to keep utilization near optimum.

LTV (loan-to-value)

The maximum amount, expressed as a percentage of collateral value, that a user can borrow against a given collateral asset on a money market.

Liquidation threshold

The collateral-to-debt ratio at which a position becomes eligible to be liquidated. Always equal to or higher than LTV.

Health factor

On Aave, the ratio (collateral value × liquidation threshold) / total debt. A position with HF below 1 can be liquidated by anyone.

Liquidation bonus

The discount a liquidator receives on seized collateral when closing an unhealthy position. Typically 5-10% on Aave V3, paid out of the borrower's collateral.

Safety Module

Aave's explicit on-chain insurance backstop. AAVE holders stake into a slashable contract (up to 30%) to absorb shortfall events; in exchange they receive staking rewards and a share of protocol fees.

GHO

Aave's native stablecoin, launched 2023. GHO is minted directly by Aave borrowers, and the interest paid on GHO loans flows to the Aave DAO treasury.

Bad debt

Outstanding loans where the borrower's collateral is worth less than the debt, leaving the protocol with an unrecoverable loss. Caused by oracle issues, market gaps, or illiquid collateral.