An onchain lending market or a curated vault quotes a yield, and the number on its own says little about what produced it. It may be interest paid by borrowers, a token subsidy that ends with its programme, or payment for a risk nobody has priced. An allocator also needs to know who absorbs a loss when a market or a vault takes one, and in what order. Both questions are answered in the protocols' own documentation and in the accounts written after markets failed. What follows explains mechanics; it is not investment, legal, tax or accounting advice.
How an overcollateralised loan works
A depositor supplies an asset to a pool or an isolated market. A borrower posts a different asset as collateral, valued by a price oracle, and draws a loan against it. Two limits govern the loan: one caps how much can be borrowed, the other marks the point at which the position can be liquidated. Compound III's documentation describes its liquidation collateral factors as "separate and higher than" its borrow collateral factors, which leaves a price buffer on every new position. Morpho Blue works with a single number per market, the liquidation loan-to-value. In each case the limit belongs to the asset or the market and is not negotiated with the borrower: the collateral is the credit decision.
The rate follows utilisation, not the borrower
Aave's V3 documentation describes an interest-rate model with two slopes either side of an optimal utilisation point: below it, borrow rates rise along the first slope; above it, they rise faster along the second. A reserve nearing full utilisation therefore becomes quickly more expensive to borrow from, which draws in supply and discourages further borrowing. Compound III uses the same shape. Its documentation describes a utilisation "kink", above which "the interest rate increases more rapidly", with supply and borrow models set by governance. Neither model looks at who the borrower is. The rate responds to how much of the pool is lent out.
Liquidation, and the bonus that pays someone to do it
On Aave V3, a position becomes eligible for liquidation when its health factor falls below 1; a liquidator repays part of the debt and receives collateral at a discount, the liquidation bonus. Aave V4, as its documentation describes it, changes both halves. Instead of a fixed close factor, liquidators "repay only enough debt to restore the position to a Target Health Factor set at the Spoke level", and the bonus grows as the health factor falls, so the riskiest positions offer liquidators the most. Compound III is built differently. Any address can call its absorb function on an underwater account; the protocol takes over the position, pays for it from its own reserves of the base asset and receives the collateral. When those reserves fall below a governance-set target, liquidators can buy the collateral from the protocol at a discount. For a depositor, the difference is who stands between them and a shortfall at the moment a position goes underwater: competing liquidators, or the protocol's own reserves.
Pooled markets, isolated markets, and where a loss stops
Aave V3 runs pooled markets in which many assets share liquidity. Its documentation presents Isolation Mode as a way to list "new or more volatile assets without introducing systemic risk to the entire protocol": an isolated asset can serve as collateral only for a set basket of assets, typically stablecoins, up to a debt ceiling. That contains shared exposure without removing it. Compound III separates by deployment: each lends one base asset against several collateral assets, collateral earns no interest, and absorptions are paid from that deployment's reserves. Morpho Blue isolates furthest. Each market is defined by five immutable parameters, the loan asset, the collateral asset, the oracle, the interest-rate model and the liquidation loan-to-value, hashed into a single identifier, and anyone can create a market from the interest-rate models and liquidation thresholds the protocol's owner has enabled. Morpho's documentation is explicit about the consequence: debt left unpaid after liquidation "is known as bad debt. This represents a loss for lenders in that market." The diversification question is whether a bad debt event stays inside the market where it happened or reaches a pool the depositor never chose.
Curated vaults: who sets the risk limits
A depositor in a curated vault does not pick markets. In Morpho's Vault V2 documentation, the owner appoints the curator and any sentinels but has no direct control over assets or risk parameters. The curator is the risk configuration role: it enables the adapters through which the vault reaches markets and sets absolute caps, a fixed amount, and relative caps, a share of the vault's assets. Most curator actions are timelocked, including raising a cap, while cutting a cap takes effect at once. An allocator moves money between enabled adapters within those caps, and a sentinel can reduce risk by deallocating, lowering caps or revoking pending changes. Depositors keep an exit: an in-kind redemption, open to anyone, lets them exchange vault shares for a position in an underlying protocol, even when the vault is illiquid, for a small penalty.
The loss rule is equally plain. Morpho's guidance for curators says that when a vault's assets fall, no shares are burned and all shareholders absorb the loss equally, in proportion to what they hold. A vault's blended yield comes from the markets its curator chose, and a bad debt event in any one of them lands on every depositor. None of that shows in a headline yield; it shows in the vault's configuration and the curator's record of setting caps.
Aave V4, as Aave describes it
Aave released a public testnet and the V4 codebase for review on 19 November 2025. Aave's changelog records the Ethereum mainnet launch on 30 March 2026, with three hubs, Core, Plus and Prime, and eleven spokes. In the documentation, the Liquidity Hub is the central source of liquidity, granting each spoke a credit line for borrowing and a debit line for supplying, and the design "evolves Aave v3's market-per-pool design into a unified Hub & Spoke model, allowing governance to introduce new features or markets without migrating liquidity." Borrowers also pay a User Risk Premium, described as "an additional interest charge applied to a user's borrowing cost based on the quality of their collateral". The changelog adds a hub and spoke for Paxos Global Dollar (USDG) on Ethereum mainnet on 25 June 2026, and V4's first multi-chain deployment, on Avalanche, on 15 July 2026. Read on 13 September 2026, it lists no later V4 entry, and V3 continues alongside it: a v3.7 rollout was completed on 29 May 2026.
Where the yield actually comes from
Aave's V3 documentation says supplier yields are "funded by borrower interest net of the reserve factor". Decomposed the way this site's review of staking yield separated validator rewards, a lending or vault yield draws on four broad sources, and they behave differently under stress.
Borrower demand for leverage, shorting and basis trades. Traders borrow stablecoins against volatile collateral to add leverage, borrow an asset to sell it short, or fund a basis trade, buying spot with borrowed money while holding a matching short futures position. This demand is organic, and the most cyclical of the four. It grows when markets rise and can vanish when they fall, as the forced deleveraging in this site's account of the 10 October 2025 liquidation cascade shows.
Stablecoin borrowing demand. Some borrowers want dollar liquidity against crypto they would rather not sell. That demand is less tied to leverage, but it still shrinks when collateral values fall.
Token incentives. Many markets and vaults pay part of the headline yield in a protocol or governance token, on top of what borrowers pay. That layer is not borrower interest. It is a subsidy, often used to attract liquidity to a new market and often time-limited. Unless the headline figure is split into the borrow-side rate and the incentive layer, it overstates what will remain once the programme ends.
Real-world asset collateral. Some onchain credit now involves tokenised real-world instruments, as collateral or as the asset held. Aave's changelog records the launch of Aave Horizon on 27 August 2025, a market "where institutions or other qualified users borrow stablecoins against real-world assets". Where such instruments are collateral, lenders are still paid by borrowers, but what stands behind the loan is an off-chain claim whose value and liquidation depend on its issuer, custodian and legal documents. Where tokenised credit is the asset held, this site's review of tokenised private credit sets out that the return is the underlying credit's own, net of fees, and that losses have been settled by fund documents and courts rather than by the token.
The risk stack, in order
Contract risk
Euler Finance, a lending protocol, was exploited on 13 March 2023 for about $197 million, according to Euler Labs' own account, published on 10 January 2024. The independent report rekt.news published on 14 March 2023 traced the loss to a donation function, donateToReserves, that did not check the health of the donor's own position, and noted that Euler had six auditors. Euler Labs says the stolen assets, worth about $240 million by then after ETH's price rose, were returned over the following three weeks, after negotiation with the exploiter. This site's threat model for DeFi covers the exploit and why audits are evidence rather than warranties. The point for a lender is narrower: the recovery came from negotiation, not from any mechanism in the market itself.
Oracle risk
On 12 May 2022, as LUNA collapsed, the Chainlink LUNA price feed used by Venus Protocol on BNB Chain stopped at a minimum price. Venus's own incident update, posted on 13 May 2022, says the feed "hit a price floor threshold and was suspended by Chainlink with a price of $0.107" at about 09:20 UTC while the market price kept falling. Accounts deposited LUNA valued at that floor and borrowed against it until a multisig paused the protocol at about 15:15 UTC, leaving a shortfall Venus put at about $14.2 million on an initial tally, to be paid down over time by its Risk Fund. The independent report on rekt.news, published the same day, put the minimum price at $0.10 and the Venus loss at $13.5 million, and described Blizz Finance on Avalanche as wiped out, with $8.3 million gone, because its timelock stopped it reacting in time. A price floor, an update rule and a fallback are configuration choices, and they are worth reading before a deposit.
Liquidation and bad debt
The mechanics above give three answers to who pays when liquidation falls short. On Aave, liquidators close positions for a bonus, and the changelog records the June 2025 Umbrella upgrade as a staking-based system "to cover bad debt". On Compound III, the protocol's reserves absorb the position first and are rebuilt as liquidators buy the seized collateral. On Morpho Blue, an unrecovered shortfall is a loss for lenders in that market only, and in a Morpho vault it is shared by every depositor. Which answer applies to a deposit is written into the protocol.
Governance and admin keys
On Aave and Compound III, parameters such as collateral factors, oracles and interest-rate models are set by governance and can be changed by it. The Venus and Blizz episode shows that controls cut both ways: a pause limited one loss, and a timelock stopped a response to the other. Morpho Blue fixes each market's parameters at creation, which moves the governance question to the choice of market and, in a vault, to whoever makes that choice. This site's diligence framework for protocol control reads signer independence, timelock length and voting-power concentration from onchain data, and it applies to a lending market as to any other protocol.
Curator or allocator risk
In a vault, the curator stands between the depositor and every market above. The questions worth asking are the curator's record of raising and cutting caps, whether it has capital of its own in the vault, and whether its allocations have gathered in markets that share one oracle or one collateral asset, rebuilding the correlated exposure that isolated markets were meant to avoid.
Stablecoin de-peg
Most lending markets and vaults are denominated, on one side or both, in a stablecoin. This site's review of stablecoins asks whether redemption at par runs through the issuer or a secondary market, and on what timetable. A lending market inherits that answer: the stable side of a loan is only as sound as the redemption route behind it.
Legal characterisation
The EU's Markets in Crypto-Assets Regulation, Regulation (EU) 2023/1114, was published in the Official Journal on 9 June 2023 and has applied since 30 December 2024. Its recital 22 says that where crypto-asset services "are provided in a fully decentralised manner without any intermediary, they should not fall within the scope of this Regulation", but the regulation does not define how decentralised is enough. Article 142 required the European Commission to report by 30 December 2024 on matters the regulation does not address, including "the necessity and feasibility of regulating lending and borrowing of crypto-assets" and the treatment of decentralised finance. Whether a vault with an identifiable curator, or a market with an active governance body, has an intermediary is a question for counsel in each jurisdiction concerned.
On Proof of Talk's programme
Three sessions at Proof of Talk's Paris edition, held 2–3 June 2026, were programmed on this subject. On 2 June, the panel "Institutional Yield in Crypto: From Bitcoin Strategies to Onchain Vaults" brought together Sunand Raghupathi, Karl Naim, Martin Derka and Evan Feng, moderated by Travis Hayes. On the morning of 3 June came the fireside "Aave V4: Scaling Onchain Lending" with Stani Kulechov, listed on Aave's website as Aave Labs CEO, moderated by Jacquelyn Melinek, roughly two months after V4 reached Ethereum mainnet. That afternoon Travis Hayes sat on a panel rather than chairing one: "Building Sustainable Yield in DeFi: Lending, Liquidity and Risk", with Tuongvy Le and Xiao-Xiao J. Zhu, moderated by Christine Lee. All three are listed on the agenda.