Leveraged capital acts as a double-edged sword, driving the pendulum of market cycles to extremes. During bull markets, it fuels asset price surges, while in recent downtrends, chain liquidations and panic triggered by leveraged funds have cast a shadow over the crypto world. Data shows that on June 14 alone, liquidation volumes on Aave and Compound on Ethereum reached $53.1 million and $45.44 million, respectively.
Lending protocols are the tools that provide leverage for on-chain capital. Different protocols employ varying oracle mechanisms, collateral ratios, and liquidation thresholds, leading to distinct risk exposures for both the protocols and their users. An analysis of the risk management frameworks of Maker, Aave, and Compound—three widely used lending protocols—reveals several key insights.
Key Findings at a Glance
- Oracle Security: All three protocols demonstrate robust oracle security. Aave and Compound source data from Chainlink, with additional validation steps. Maker has built a similar self-sustained system with a one-hour price delay.
- Stablecoin Support: USDT, the largest stablecoin by market cap, is not accepted as collateral on any of the three protocols. In contrast, USDC is well-supported across all of them.
- Capital Efficiency: Aave generally offers higher capital utilization, with loan-to-value (LTV) ratios for common assets often equal to or greater than those on Compound. Aave's support for stETH as collateral has attracted over $1 billion in deposits.
- Extreme Scenario Mechanisms: Both Maker and Aave have mechanisms to mint additional tokens and conduct auctions to cover bad debt. While not explicitly stated, Compound could implement similar measures through its governance process. Maker's Emergency Shutdown module adds an extra layer of protection.
- Borrowing Caps: Maker imposes debt ceilings on each vault type. Compound has borrowing caps for certain assets, while Aave does not employ this restriction.
- Revenue Models: All three protocols generate income from borrowing interest. Maker uses its surplus to buy back and burn MKR. Aave distributes a portion of its revenue to stakers in its Safety Module. Compound relies on governance to manage reserve extraction.
Deep Dive into Maker's Risk Framework
As the pioneer of decentralized stablecoins, the Maker protocol mints the DAI stablecoin through over-collateralization. DAI has become a cornerstone of DeFi, integrated into hundreds of applications. The ecosystem comprises users, maintainers, and governance participants.
Oracle System
Oracles are critical for lending protocols, determining when liquidations occur and how much can be borrowed. They are also a common attack vector, such as in flash loan attacks where market manipulation exploits price feeds.
Maker's oracle design is a industry benchmark. Its co-founder noted that Maker pioneered the off-chain data aggregation and medianizer design later adopted by Chainlink. The process involves:
- Feeds Selection: Governance selects anonymous individuals and public organizations to provide price data.
- Price Sourcing: Each feed pulls the median price from a set of exchanges and pushes it to a Secure Scuttlebutt network with a timestamp and signature.
- Data Aggregation: Relayers read these prices, aggregate the data, and send it to a Medianizer contract.
- Median Price Calculation: The Medianizer takes the median of these values and publishes it as a queued reference price.
- Price Delay: A one-hour delay (configurable via governance) exists between price publication and its use by the system.
Using the median price and a delay makes manipulation significantly harder, requiring collusion from over half the feeds and exposing public entities to legal risk.
Collateralization & Liquidation
Maker uses a Collateralization Ratio (collateral value/debt value). Different vaults for the same asset (e.g., ETH-A, ETH-B, ETH-C) have varying minimum ratios and associated stability fees. A lower ratio means higher risk and a higher fee. The minimum ratio is the liquidation threshold.
For example, in an ETH-C vault with a 170% ratio, 1 ETH worth $1,215.5 could borrow a maximum of 715 DAI. Users must manage their risk above this threshold. As of June 27, the average collateralization ratio in ETH-C vaults was ~399%, indicating low systemic risk.
Auctions and Bad Debt
Maker employs three auction types handled by external "Keepers":
- Surplus Auctions: Sell excess DAI from stability fees for MKR, which is burned, reducing supply.
- Collateral Auctions: Sell a vault's collateral if its ratio falls below the minimum to repay its DAI debt.
- Debt Auctions: In extreme cases where collateral auctions fail to cover the debt (e.g., March 2020 "Black Thursday"), the protocol mints and auctions new MKR to raise DAI, increasing MKR supply.
Emergency Shutdown
In a severe emergency like a hack, MKR holders can trigger an Emergency Shutdown by locking 50,000 MKR. Vault owners can reclaim excess collateral, and DAI holders can redeem their tokens for a proportional share of the system's collateral assets after a waiting period.
Analyzing Aave's Multi-Chain Protocol
Aave is a multi-chain lending protocol where users deposit to earn yield or supply collateral to borrow other assets. A reserve factor (10-35%) determines the percentage of borrowing interest the protocol takes for DAO funding and contributors, with the rest going to depositors.
Oracle Mechanism
Aave uses Chainlink oracles. Multiple independent nodes report off-chain data. A consensus algorithm aggregates these reports, and a single transaction updates the on-chain price if the off-chain data fluctuates by more than 0.5% or if 3600 seconds have passed since the last update. For ETH/USD, 31 nodes participate, with a minimum of 21 required responses.
Loan-to-Value (LTV) and Liquidation
LTV dictates the maximum value one can borrow against 1 unit of collateral. Key points:
- USDT, BUSD, and several other stablecoins have a 0% LTV, meaning they cannot be used as collateral due to perceived counterparty risk. Aave's risk assessment gave USDT a low trust rating (D+).
- USDC has the highest LTV at 86%.
- The liquidation threshold is always higher than the maximum LTV, providing a buffer. For USDC, the LTV is 86% and the liquidation threshold is 88%.
Aave's support for stETH (LTV: 73%, Liquidation: 75%) has been a major success, attracting $1.56 billion in deposits, comprising 23.8% of total Aave V2 deposits as of June 27.
Safety Module
The Safety Module (SM) is Aave's innovative risk mitigation layer. Users stake AAVE or liquidity pool tokens to earn fees and provide insurance. In case of a shortfall event (liquidation risk, smart contract bug, oracle failure), up to 30% of the staked capital can be slashed to cover the deficit. If the slashed funds are insufficient, the protocol can mint new AAVE tokens to auction off for recovery. Staking funds have a 10-day cooldown before redemption.
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Understanding Compound's Governance-First Approach
Compound is an Ethereum lending protocol known for its proxy upgrade pattern, allowing for seamless governance-led upgrades. Like Aave, it uses a reserve factor (7% for stablecoins, 20% for ETH/WBTC, 25% for higher-risk assets) to collect fees, which can be extracted via governance.
Oracle System with Checks
After a November 2020 incident where DAI spiked to $1.30 on a single exchange (Coinbase), causing $89 million in liquidations, Compound upgraded its oracles. It now uses Chainlink as its primary data source but adds a critical check: the Price Feed contract validates the Chainlink price against a bounds check derived from the Uniswap V2 time-weighted average price (TWAP) for that asset. The new price is only accepted if it falls within this allowable range.
Collateral Factors
An asset's Collateral Factor (CF) on Compound ranges from 0% to 90%, based on liquidity. A 0% CF means it cannot be used as collateral (like USDT). Common CFs are:
- USDC: 84%
- DAI: 82%
- ETH: 82%
- WBTC: 70%
These values are generally lower than or equal to Aave's LTVs for the same assets, making Compound slightly more conservative in its capital efficiency.
Liquidation Process
Compound uses an "Account Liquidity" metric to gauge position health. It is calculated as:
(Sum of all deposits × their collateral factor) - (Sum of all borrows)
A negative Account Liquidity means the position is eligible for liquidation. While Compound's documentation does not explicitly outline a recovery mechanism for system-wide bad debt, its powerful and agile governance system allows token holders to vote on and implement emergency measures, such as minting new COMP tokens, if such a scenario arises.
Frequently Asked Questions
What is the main difference between LTV and collateral factor?
They are essentially the same concept with different names. Both Loan-to-Value (Aave) and Collateral Factor (Compound) represent the maximum percentage of an asset's value that you can borrow against. For example, an 80% LTV/CF means you can borrow up to $0.80 for every $1.00 of collateral you deposit.
Why is USDT not accepted as collateral on these major protocols?
The decision is primarily based on perceived counterparty and regulatory risk. Protocols like Aave have conducted risk assessments that highlight concerns about Tether's redemption process, ongoing legal challenges, and the transparency of its reserves. USDC, being issued by a regulated US entity with attested reserves, is generally viewed as a lower-risk asset by these decentralized governance communities.
How does the one-hour price delay in Maker's oracles improve security?
The delay is a crucial security feature. It prevents attackers from using flash loans to quickly manipulate the market price on exchanges and immediately exploit that manipulated price for liquidation attacks or stealing collateral on Maker. By the time the manipulated price would be used by the system, the market has likely corrected, nullifying the attack.
What happens if my position gets liquidated?
When your loan's collateralization ratio drops below the liquidation threshold, liquidators can repay a portion of your outstanding debt in exchange for a discounted amount of your collateral. This penalty (the discount) is designed to incentivize liquidators to act quickly and protect the protocol from under-collateralized debt. The exact liquidation penalty varies by protocol and asset.
Can these protocols really handle a market crash like March 2020?
The events of March 2020 ("Black Thursday") were a major stress test. Maker did experience a shortfall, which it covered through a debt auction (minting and selling MKR). This event led all major protocols to significantly strengthen their risk parameters, add new safety modules (like Aave's), and improve oracle robustness. While they are more resilient now, a crash of unprecedented speed and severity could still test their limits.
Is my money safer in one protocol over the others?
There is no definitive answer. Each protocol employs a different mix of risk trade-offs. Maker offers strong oracle security with a delay and a proven emergency shutdown. Aave provides high capital efficiency and a dedicated capital buffer (Safety Module). Compound leverages robust governance for adaptability. The "safest" choice depends on your assessment of these different risk models and the specific assets you're using.