Overcollateralized Lending: Aave, Compound, and MakerDAO

Why Overcollateralization?

In traditional finance, lenders evaluate borrowers through credit scores, employment history, income verification, and legal recourse in the event of default. None of these mechanisms exist on-chain. Blockchain addresses are pseudonymous, carry no credit history, and operate beyond the reach of conventional legal enforcement. Overcollateralization solves this problem through economic incentives: borrowers must lock collateral worth more than their loan, ensuring the protocol can always recover lent funds even if the borrower disappears.

This model restricts DeFi lending to specific use cases — leveraged trading, liquidity provision, tax-efficient asset access, and yield farming — but it provides a robust, trustless credit system that has processed hundreds of billions of dollars in lending volume without requiring a single credit check.

Collateral Factors and LTV Ratios

Each protocol assigns risk parameters to every supported asset. The Loan-to-Value (LTV) ratio determines how much a user can borrow against their collateral. A collateral factor of 75% means $10,000 in ETH allows borrowing up to $7,500. These parameters reflect the asset's volatility, liquidity depth, and market capitalization:

• Blue-chip assets (ETH, WBTC, stablecoins) receive higher LTV ratios (75–90%) due to deep liquidity and lower volatility.
• Mid-cap tokens receive moderate LTV ratios (50–70%).
• Long-tail assets may receive low LTV ratios (30–50%) or be restricted to isolation mode (Aave) to limit systemic exposure.

The gap between the LTV ratio and the liquidation threshold serves as a buffer zone, giving borrowers time to add collateral or repay debt before liquidation is triggered.

Compound Protocol

Architecture

Compound's architecture centers on the Comptroller contract, which acts as the risk management layer for the entire protocol. The Comptroller maintains the list of supported markets, enforces collateral factors, and validates that all borrow and withdrawal operations maintain sufficient collateralization. Each asset market is represented by a separate cToken contract that holds the underlying deposits and manages interest accrual.

cToken Model

When users supply assets, they receive cTokens at an exchange rate that increases monotonically as interest accrues. The exchange rate is calculated as:

Exchange Rate = (Total Cash + Total Borrows - Total Reserves) / Total cToken Supply

This design means cToken balances remain constant while their redemption value grows. A user who received 50,000 cUSDC months ago can redeem them for progressively more USDC as interest accumulates. cTokens are standard ERC-20 tokens and can be transferred, used in other protocols, or traded on secondary markets.

Interest Rate Model

Compound uses a JumpRateModel with configurable parameters per market. The model defines a base rate, a multiplier for the normal utilization range, a jump multiplier for utilization above the kink, and the kink point itself. For stablecoins, the kink is typically set around 80%, with a moderate slope below and a steep slope above to preserve withdrawal liquidity.

COMP Governance

The COMP token governs all protocol parameters through on-chain voting. Token holders can propose changes to collateral factors, interest rate models, market listings, and reserve factors. Proposals require a minimum threshold of COMP to submit and a majority vote to pass, followed by a timelock delay before execution. Compound was one of the first protocols to implement fully on-chain governance, and its Governor framework has been widely adopted across DeFi.

Compound V3 (Comet)

Compound V3 represents a significant architectural departure. Instead of multiple isolated cToken markets, each Comet deployment has a single borrowable base asset (e.g., USDC) with multiple collateral assets. This simplifies risk management, reduces gas costs, and allows the protocol to optimize interest rates for a single lending market. Suppliers of the base asset earn interest, while collateral deposits do not earn yield but enable borrowing.

Aave Protocol

Architecture

Aave's architecture is built around a Pool contract that manages all lending and borrowing operations. The protocol maintains a centralized registry of asset configurations, risk parameters, and oracle sources. Aave V3 introduced a modular design with separate contracts for supply logic, borrow logic, liquidation logic, and flash loan logic, connected through the Pool contract.

aToken Model

Unlike Compound's exchange-rate model, Aave uses rebasing aTokens that maintain a 1:1 peg with the underlying asset. When a user deposits 1,000 USDC, they receive 1,000 aUSDC. As interest accrues, their aUSDC balance automatically increases — to 1,001, then 1,002, and so on. This is implemented through a scaled balance mechanism where the contract stores a normalized balance and multiplies it by a liquidity index to compute the actual balance at any point in time.

Variable vs. Stable Rates

Aave offers borrowers a choice between variable and stable interest rates:

• Variable rate: Fluctuates based on real-time utilization, identical to the standard DeFi lending model. Lower on average but subject to spikes during high-utilization periods.
• Stable rate: Provides a fixed rate at the time of borrowing, offering predictability. However, the protocol reserves the right to rebalance stable rates under extreme conditions to protect solvency. Stable rates are typically higher than variable rates to compensate for the reduced volatility.

Flash Loan Integration

Aave pioneered flash loans as a core protocol feature. Any user can borrow any amount of any asset from Aave's pools without collateral, provided the loan is repaid within the same transaction. Aave charges a 0.05% fee on flash loans (reduced from the original 0.09%), which accrues to depositors. Flash loans are covered in detail in the next article in this series.

Isolation Mode

Aave V3 introduced isolation mode for newly listed or higher-risk assets. When an asset is designated as an isolated collateral, users who supply it can only borrow stablecoins (or other specified assets) up to a defined debt ceiling. This limits the systemic risk that a single volatile asset can impose on the broader protocol. Once governance gains confidence in the asset's behavior, isolation mode can be removed.

Efficiency Mode (eMode)

Efficiency mode allows assets within the same category (e.g., ETH-correlated assets like ETH, stETH, and cbETH, or stablecoins like USDC, USDT, and DAI) to be borrowed against each other with significantly higher LTV ratios and lower liquidation penalties. This reflects the reduced price divergence risk between correlated assets. For example, borrowing USDC against USDT collateral in eMode may allow an LTV of 97% compared to the standard 80%, dramatically improving capital efficiency for specific strategies.

MakerDAO (Sky)

CDP/Vault System

MakerDAO operates fundamentally differently from Aave and Compound. Rather than lending out deposited assets, the protocol enables users to mint DAI (a decentralized stablecoin) against locked collateral. Users open Vaults (formerly called CDPs — Collateralized Debt Positions), deposit collateral (ETH, WBTC, stablecoins, real-world assets), and generate DAI up to the allowed collateral ratio.

The system functions more like a decentralized central bank than a lending market. DAI is not borrowed from other depositors; it is created by the protocol when a Vault is opened and destroyed when the debt is repaid. This design means Maker has no supply side in the traditional sense — the "lender" is the protocol itself.

Stability Fees

Instead of market-driven interest rates, MakerDAO charges stability fees set by governance. Each collateral type (called an ilk) has its own stability fee, reflecting the risk profile of that asset. Stability fees accrue continuously on outstanding DAI debt and must be paid in DAI upon Vault closure. Revenue from stability fees flows to the Surplus Buffer and, once sufficient reserves are accumulated, to MKR token buybacks and burns.

Liquidation Mechanism

When a Vault's collateralization ratio falls below the liquidation ratio (e.g., 150% for ETH-A), the Vault becomes eligible for liquidation. Maker V2 uses a Dutch auction mechanism (Liquidations 2.0) where collateral is offered at a declining price until a keeper (liquidator) purchases it. This replaced the earlier English auction system, which proved inefficient during the March 2020 market crash when some Vaults were liquidated for zero DAI due to network congestion.

Peg Stability Module (PSM)

The PSM allows direct 1:1 swaps between DAI and approved stablecoins (primarily USDC) with minimal fees. When DAI trades above $1.00, arbitrageurs deposit USDC into the PSM to mint DAI and sell it. When DAI trades below $1.00, they buy DAI cheaply and redeem it for USDC. The PSM has been highly effective at maintaining DAI's peg but has drawn criticism for making DAI heavily dependent on centralized stablecoin backing.

DAI Savings Rate (DSR)

The DAI Savings Rate allows any DAI holder to deposit into the DSR contract and earn yield. The rate is set by MakerDAO governance and is funded by stability fee revenue. The DSR serves as a monetary policy tool: increasing it incentivizes DAI holding (reducing supply, pushing the price up), while decreasing it encourages DAI selling (increasing supply, pushing the price down). In 2023, the DSR was aggressively raised to 8% as part of Maker's strategy to grow DAI supply.

Protocol Comparison

Choosing Between Protocols

The appropriate protocol depends on the use case:

• Simple lending/borrowing with broad asset support: Aave V3 offers the widest asset selection, multi-chain deployment, and features like eMode and isolation mode for sophisticated risk management.
• Stablecoin-focused borrowing with minimal complexity: Compound V3's single-base-asset model provides a streamlined experience with lower gas costs for USDC-centric strategies.
• Decentralized stablecoin minting: MakerDAO remains the dominant protocol for generating DAI against diverse collateral types, including real-world assets.
• Flash loan strategies: Aave is the primary venue, offering flash loans across all supported assets with a 0.05% fee.