The State of DeFi Lending & Borrowing in Web3: Is the System a House of Cards?

The decentralized finance (DeFi) landscape has revolutionized the way we think about borrowing and lending. Platforms like Compound and Aave have made it possible for users to borrow and lend cryptocurrencies without intermediaries, ushering in a new era of financial autonomy. By leveraging blockchain technology and smart contracts, DeFi protocols offer users instant access to liquidity, trustless transactions, and a sense of empowerment in the Web3 ecosystem. However, beneath this seemingly flawless architecture lies a potential weakness—an inherent risk that could unravel the entire system, especially in moments of global crisis.

The DeFi Lending Model: A Brief Overview

At the core of many DeFi lending platforms like Compound and Aave is the single liquidity pool model. In this model, users deposit their assets into a shared pool, which is then available to borrowers. To secure loans, borrowers must post collateral, typically in the form of crypto assets like Ethereum (ETH) or stablecoins like USDC. The interest rate that borrowers pay and lenders earn is determined algorithmically, based on the supply and demand for liquidity within the pool.

This system sounds elegant on the surface, but it introduces several risks that often go unnoticed. In both Compound and Aave, assets deposited as collateral can be re-lent to other borrowers. This means that the same asset could effectively be "working" multiple times in the system, generating interest across several loans—a process that can be akin to financial engineering in traditional finance.

How the Lending Pools Drive Interest Rates

In both Aave and Compound, the interest rates borrowers pay fluctuate based on the utilization rate of the pool, which is the percentage of assets that have been lent out relative to the total available liquidity. When most of the pool’s assets are being borrowed, interest rates rise to encourage more lenders to deposit. Conversely, when there's an excess of liquidity, interest rates fall to encourage borrowing.

This supply-and-demand mechanism works reasonably well in normal market conditions. However, the key risk lies in the fact that the collateral itself can be re-lent, creating multiple layers of exposure. When collaterals are continuously reused, the effective risk multiplies throughout the system, and if something catastrophic happens—like a market crash or geopolitical crisis—the entire DeFi ecosystem could be thrown into disarray.

The Ponzi-Like Nature of Single-Pool Models

At its worst, this system can begin to resemble a Ponzi scheme. Why? Because the sustainability of the system relies on a constant influx of new liquidity. As long as more people are willing to lend and borrow within the platform, the interest rates can remain somewhat stable, and the ecosystem thrives. However, if there’s a sudden shock to the system—like the onset of World War III or a massive global market crash—liquidity could dry up overnight. In that case, the collateralized loans in these single pools may no longer be sufficient to cover the massive withdrawals and liquidations that follow.

The collateral held in these platforms isn’t always as secure as it seems. Because the collateral can be re-lent, it means the protocol is leveraging the same assets across multiple loans. If the value of the collateral plummets due to a market-wide selloff, a cascading series of liquidations could occur. Since the pool's collateral is spread thin across multiple loans, the entire system could become illiquid very quickly, leaving borrowers and lenders alike with significant losses.

Is There a Way Out?

The risks outlined above are not merely theoretical—they represent the very real fragility of the current DeFi lending model. The reliance on a single liquidity pool, combined with the practice of re-lending collateral, creates systemic risks that could lead to a complete breakdown in times of crisis.

Clynto’s Borrower-Centric Approach

Fortunately, not all DeFi protocols follow this precarious model. Clynto takes a fundamentally different approach to lending and borrowing. Instead of pooling assets in a single, centralized pool, Clynto allows borrowers to retain ownership and control of their collateral through borrower-centric loan agreements. This ensures that assets are not re-lent multiple times, significantly reducing the risk of cascading failures in times of market volatility.

Additionally, Clynto's governance model allows the community to vote on interest rates and loan-to-value (LTV) ratios, ensuring a fairer, more transparent approach to lending. By giving the power to the users, Clynto aims to create a more resilient system that can withstand even extreme market conditions.

Conclusion

While platforms like Compound and Aave have undoubtedly pushed the boundaries of what’s possible in DeFi, their single-pool models expose users to considerable risk—especially in a crisis scenario. The practice of re-lending collateral can create a house of cards that could come crashing down if global markets falter.