Decentralized finance uses blockchain contracts to perform activities such as exchanging assets, lending against collateral, and allocating money to trading strategies. The interesting feature is that the output of one activity can become the input to another. A token received from a lender can be used in another application, which may issue another claim in return.
That flexibility makes new arrangements possible. It also means a simple-looking balance can depend on several systems. To understand the investment, follow where the money went and what must happen to get it back.
What a lending position actually contains
Suppose you supply $10,000 of a volatile asset to a lending protocol and borrow $6,000 of a dollar token. You still have exposure to the collateral’s price, while owing the borrowed tokens plus interest. The loan has not removed the original investment risk; it has added a debt obligation against it.
Protocols can use different limits for opening a loan and for liquidating it. The loan-to-value limit controls borrowing capacity. The liquidation threshold defines when the collateral buffer has become insufficient. Aave’s borrowing guide separates these parameters and explains that borrowing rates can change as utilization changes.
Utilization measures how much of a lending pool’s supplied capital is borrowed. When available liquidity becomes scarce, the rate model can raise the cost of borrowing. A trade financed at a favorable initial rate therefore needs to remain viable if that rate changes.
The liquidation buffer
For a simplified position with an 80% liquidation threshold, the health factor is collateral value × 80% ÷ debt value. Our $10,000 collateral and $6,000 debt give a health factor of about 1.33. If the collateral falls to $7,500 and debt is unchanged, the ratio reaches 1. Interest growth can bring it there sooner.
The 80% threshold is a teaching assumption, not a universal setting. Aave’s health-factor documentation explains that a value below 1 permits liquidation under the relevant rules. A liquidator repays some eligible debt and receives collateral, including the applicable incentive. The borrower gives up assets to settle that obligation.
Debt has a price as well as collateral. If you borrow a volatile token, its rising dollar value can worsen the ratio even when the collateral price is unchanged. Two correlated assets may appear stable relative to each other until the relationship breaks. A buffer measured in one quiet period is not a guarantee about another.
Why a loop amplifies the exposure
Now imagine borrowing $5,000 against a $10,000 holding and using the proceeds to buy more of the same asset. The account has $15,000 of gross exposure and $5,000 of debt, leaving $10,000 of equity. A 10% fall in the asset reduces the holding to $13,500. Ignoring interest, equity is $8,500: a 15% loss.
Repeating the borrowing-and-buying process can raise exposure further. The apparent collection of deposits and receipt tokens still contains the same underlying price bet. Count the original assets and debts once; do not treat each receipt as new net wealth.
Unwinding the layers
Suppose a receipt token from the lending market is placed in a second strategy. Exiting now may require leaving that strategy, retrieving the receipt, repaying debt, and withdrawing collateral. A pause, queue, thin market, or missing permission at an intermediate stage can block the whole route.
The repayment asset has to be available where the debt is owed. Funds locked elsewhere in the portfolio may not arrive before the health factor crosses the threshold. This is the practical difference between having enough total wealth and having enough usable liquidity.
Build the economic description before adding another layer: assets owned, debt owed, rate paid, threshold applied, additional rewards received, and steps required to unwind. Rewards denominated in a different token should be valued separately from interest owed. Once these are visible, the strategy can be compared with simply holding the asset or using a less complicated form of financing.