Lending & Borrowing Protocols

Lending protocols are core DeFi primitives that enable users to earn yield on deposits and borrow against collateral.

How Lending Works

Supplying (Lending)

1. User deposits tokens into a lending pool
2. User receives pool tokens (e.g., deposit SOL, receive cSOL)
3. Pool tokens earn interest (redeem for more SOL over time)
4. Can withdraw anytime (if liquidity available)

Borrowing

1. User deposits collateral (e.g., SOL)
2. User borrows against collateral (e.g., borrow USDC)
3. User pays interest on borrowed amount
4. Must maintain collateralization ratio or face liquidation

Interest Rates

Interest rates are algorithmic (set by supply/demand, not by humans).

Utilization Rate

Utilization = Total Borrowed / Total Supplied

Example:
Total Supplied: 1,000 SOL
Total Borrowed: 700 SOL
Utilization: 70%

High utilization → higher borrow rates (to incentivize more supply)

Interest Rate Model

Typical model has two slopes:

if Utilization < 80%:
  Borrow APY = Base + (Utilization × Multiplier)
else:
  Borrow APY = Base + (80% × Multiplier) + ((Utilization - 80%) × JumpMultiplier)

Example parameters:
Base = 2%
Multiplier = 5%
JumpMultiplier = 100%

At 70% utilization:
  Borrow APY = 2% + (70% × 5%) = 5.5%

At 90% utilization:
  Borrow APY = 2% + (80% × 5%) + (10% × 100%) = 16%

The "kink" at 80% prevents the pool from running out of liquidity.

Supply APY Calculation

Supply APY = Borrow APY × Utilization × (1 - Reserve Factor)

Reserve Factor = 10% (protocol fee)
Utilization = 70%
Borrow APY = 8%

Supply APY = 8% × 70% × 90% = 5.04%

Overcollateralization

Crypto lending requires overcollateralization (you can't borrow more than your collateral value).

User deposits: 10 SOL @ $100 = $1,000
Max LTV (Loan-to-Value): 75%
Max borrow: $1,000 × 75% = $750 USDC

Why overcollateralization?

• No credit scores in DeFi
• Instant liquidation if collateral drops
• Protects lenders from bad debt

Collateralization Ratios

LTV (Loan-to-Value)

Maximum you can borrow against collateral:

SOL LTV: 75%
Means: For every $100 SOL, borrow up to $75

Liquidation Threshold

When your position can be liquidated:

SOL Liquidation Threshold: 80%
Means: If debt reaches 80% of collateral value → liquidation

Liquidation threshold > LTV provides a safety buffer.

Health Factor

Health Factor = (Collateral Value × Liquidation Threshold) / Debt Value

Example:
Collateral: 10 SOL @ $100 = $1,000
Liquidation Threshold: 80%
Debt: $750 USDC

Health Factor = ($1,000 × 0.8) / $750 = 1.067

If Health Factor < 1.0 → Liquidatable

Liquidations

When a position becomes undercollateralized, liquidators can repay the debt and seize collateral.

Liquidation Process

1. Health factor drops below 1.0
2. Liquidator repays portion of debt (close factor)
3. Liquidator receives collateral + bonus
4. Remaining position (if any) is healthier

Example

Borrower:
Collateral: 10 SOL @ $90 = $900
Debt: $750 USDC
Liquidation Threshold: 80%
Health Factor: ($900 × 0.8) / $750 = 0.96 ❌

Liquidation:
Close Factor: 50% (can liquidate up to 50% of debt)
Liquidator repays: $375 USDC
Collateral seized: $375 / $90 = 4.17 SOL
Liquidation Bonus: 5%
Actual seized: 4.17 × 1.05 = 4.38 SOL

After liquidation:
Borrower has: 5.62 SOL, $375 debt
Health Factor: ($506 × 0.8) / $375 = 1.08 ✅

Close Factor

Limits how much of a position can be liquidated at once:

Close Factor = 50%
Means: Max 50% of debt can be repaid in one liquidation

Prevents: Liquidating entire position when only slightly undercollateralized

Risk Parameters

Each asset has custom risk parameters:

More volatile/risky assets → lower LTV, higher liquidation bonus.

Isolated Pools

To manage risk, protocols create isolated pools:

Main Pool: SOL, USDC, USDT, ETH (blue-chip assets)
Isolated Pool 1: SOL + New Token X
Isolated Pool 2: USDC + Experimental Asset Y

If one isolated pool has bad debt, it doesn't affect others.

Borrowing Strategies

Leveraged Long

1. Deposit 10 SOL as collateral
2. Borrow 7 SOL worth of USDC
3. Buy 7 more SOL with USDC
4. Now have 17 SOL exposure with 10 SOL capital
5. If SOL ↑ 10%, profit is 17% (minus borrow costs)

Yield Farming

1. Deposit stablecoins, borrow SOL
2. Use SOL in high-APY liquidity pool
3. Earn more from LP fees than borrow cost
4. Profit = LP APY - Borrow APY

Short Position

1. Deposit USDC collateral
2. Borrow SOL
3. Sell SOL for USDC
4. If SOL drops, buy back cheaper and repay

Oracle Dependency

Lending protocols rely on oracles for price feeds:

Pyth Network

• Pull-based oracle (request price on-demand)
• Sub-second updates
• 350+ price feeds

Switchboard

• Decentralized oracle network
• Customizable feeds
• TEE (Trusted Execution Environment) support

Oracle Risks

• Stale prices: If oracle doesn't update, liquidations may fail or be unfair
• Manipulation: Flash loan attacks can manipulate some oracles
• Downtime: If oracle is down, protocol may pause

Mitigation: Use multiple oracles, TWAP (Time-Weighted Average Price), circuit breakers.

Protocol Revenue

Reserve Factor: 10%
Total Interest Paid: $100,000
To Suppliers: $90,000
To Protocol: $10,000

Protocols earn from the spread between borrow and supply rates.

Real-World Examples

Solend

• TVL: ~$300M
• Main pool + multiple isolated pools
• Pyth oracles
• SLND token rewards

MarginFi

• TVL: ~$600M
• Risk-adjusted portfolio margin
• Integrated with DEXs for leveraged trading

Kamino Finance

• TVL: ~$1.8B
• Focuses on automated liquidity strategies
• Multiply (leveraged yield vaults)

Next Challenge

You'll implement the constant product AMM formula with fees, price impact, and liquidity calculations.