Trail notes
- DeFi lending protocols are smart contracts that pool deposits and lend them to borrowers who lock up more collateral than they borrow.
- Three numbers matter most: loan-to-value (how much you can borrow), the liquidation threshold (where trouble starts) and the health factor (how close you are).
- Interest rates usually float with how much of the pool is borrowed, so your cost or yield can change quickly.
- If your health factor drops below 1, others can repay part of your debt and take some of your collateral at a discount.
- In Canada, the CSA reminded crypto-backed lending platforms on 2025-10-22 that they may need registration.
How a lending protocol works
A lending protocol is a set of smart contracts that acts like a pooled money market. Lenders deposit tokens into a shared pool and earn interest. Borrowers lock collateral and draw loans from that pool. No loan officer reviews anything; the code checks only whether your collateral is worth enough.
Because there is no credit check and no way to chase a borrower who disappears, almost all DeFi lending is over-collateralized: you must deposit more value than you borrow. If your collateral falls in value, the protocol does not phone you. It lets other participants close part of your position automatically.
People borrow against crypto for many reasons: to get stablecoins without selling an asset, to fund another position, or to use leverage. Each reason has the same core risk, which is that the collateral can fall faster than you can react.
LTV, liquidation threshold and health factor
Each collateral type has its own settings, chosen by the protocol’s governance. The names vary slightly, but the ideas are consistent:
- Loan-to-value (LTV): the maximum you can borrow as a share of your collateral’s value. With a 75% maximum LTV, $10,000 of collateral lets you borrow up to $7,500.
- Liquidation threshold: a higher line, say 80%, at which your position becomes eligible for liquidation.
- Health factor: (collateral value × liquidation threshold) ÷ debt value. Above 1 you are safe for now. At or below 1, you can be liquidated.
- Liquidation penalty or bonus: the discount a liquidator receives on your collateral, which is your cost.
Prices come from oracles, outside data feeds that tell the contract what your collateral is worth. If the oracle is wrong or delayed, your health factor is wrong too. Our guide to oracles and real-world data explains why.
See the full infographic with notes.
Worked example: from safe to liquidated
Two lessons fall out of the numbers. First, borrowing at half your collateral value felt conservative, yet a 37.5% drop, which crypto markets have seen many times, was enough to trigger liquidation. Second, liquidation is not a full wipe-out in this design, but the penalty is real and markets can keep falling after the first liquidation.
Try your own numbers in our liquidation explorer or the borrow-health calculator listed below.
How interest rates are set
Most lending protocols use an interest rate model tied to utilization, the share of deposited tokens that are currently borrowed. When utilization is low, rates are low to encourage borrowing. As it rises, rates climb. Many models have a “kink”: above a target level, rates rise steeply to pull utilization back down so lenders can still withdraw.
| Pool utilization (hypothetical) | Borrow rate (hypothetical) | What it signals |
|---|---|---|
| 20% | 2% | Plenty of idle deposits |
| 60% | 5% | Normal demand |
| 80% (target) | 8% | Near the kink |
| 95% | 40% | Pool stretched; withdrawals may be hard |
Lenders earn a share of what borrowers pay, so a lender’s rate also floats. A high advertised deposit rate can mean the pool is close to fully borrowed, which is exactly when withdrawing becomes difficult.
What can go wrong
- Fast price drops: collateral can gap down before you can add more or repay.
- Oracle problems: a stale or manipulated price can liquidate healthy positions or let bad debt build up.
- Bad debt: if collateral cannot be sold for enough during a crash, the pool, and therefore lenders, absorb the shortfall.
- Smart contract bugs: code risk applies to every deposit. See smart contract risk.
- Stablecoin depegs: a borrowed or deposited stablecoin can lose its peg and change your health factor overnight.
- Liquidity crunches: at very high utilization, lenders may have to wait to withdraw.
On 2025-10-22 the CSA reminded crypto-backed lending platforms that their activities may involve trading or distributing securities that require registration, and cautioned investors to check that a platform is registered or has exemptive relief. As of 2026-10-30, the CRA has published no DeFi-specific guidance on lending or borrowing. See check a platform and DeFi transactions and tax.
How to borrow more carefully
If you choose to borrow, the habits below reduce the chance of an ugly surprise. They do not remove the risk.
- Set your own target health factor well above the minimum, and decide in advance what you will do if it falls.
- Work out the price at which you would be liquidated, and compare it with how far the asset has fallen before.
- Keep spare funds ready to repay or top up, outside the protocol.
- Prefer borrowing an asset whose value is not tied to your collateral’s value in a way that magnifies losses.
- Watch the borrow rate; a variable rate can climb sharply when pools get busy.
- Read our liquidation risk page before you take on leverage.
Your checklist
Questions people ask
What is a health factor in DeFi lending?
A health factor is your collateral value multiplied by its liquidation threshold, divided by your debt. Above 1 your position is not liquidatable; at or below 1, others can repay part of your debt and take some collateral at a discount.
Why do DeFi loans require more collateral than the loan?
Because there are no credit checks or collection agencies, protocols protect lenders by requiring collateral worth more than the loan and by liquidating positions automatically when that cushion gets too thin.
What happens when a DeFi loan is liquidated?
A liquidator repays part of your debt and receives an equal value of your collateral plus a bonus. You keep what you borrowed, but you lose the bonus amount, and your remaining position may still be at risk if prices keep falling.
Are crypto lending platforms regulated in Canada?
They can be. On 2025-10-22 the CSA reminded crypto-backed lending platforms that they may need to register with securities regulators, and told investors to check registration or exemptive relief before using one.
Sources and dates
- Decentralized finance (DeFi) — ethereum.orgreference
No date shown on page · checked 2026-10-31. Overview of DeFi building blocks on Ethereum. - Oracles — ethereum.orgreference
No date shown on page · checked 2026-10-31. How off-chain data reaches smart contracts, and oracle risks. - Introduction to smart contracts — ethereum.orgreference
No date shown on page · checked 2026-10-31. What a smart contract is and how it executes. - CSA reminds crypto-backed lending platforms of potential regulatory requirements — Canadian Securities Administratorsin force
Page date 2025-10-22 · checked 2026-10-30. Crypto-backed lending may involve securities requiring registration; check registration or exemptive relief. - Crypto platforms authorized to do business with Canadians — Canadian Securities Administratorsreference
Page date 2026-09-18 · checked 2026-10-30. The official list of authorized platforms, with links to each decision. - Information for crypto-asset users and tax professionals — Canada Revenue Agencyin force
Page date 2025-10-29 · checked 2026-10-30. CRA's current crypto-asset guidance set (replaced the older 'Guide for cryptocurrency users').
Education only. Nothing on this page is financial, investment, tax or legal advice, or a recommendation to buy, sell, stake, lend or borrow any crypto-asset. Crypto-assets can lose some or all of their value and are not covered by CDIC. Canadian rules change: check the dated sources above and talk to a qualified professional about your situation. Full disclaimer.