Lending, Borrowing, Liquidation: how does Folks Finance work?
To fully comprehend Folks Finance and other DeFi lending protocols, users should know how the lending, borrowing, and liquidation mechanisms work, considering several economic and technical factors.
Folks Finance is the leading capital markets protocol for lending and borrowing in the Algorand DeFi ecosystem. Basically, through the lending operations, Folks users can deposit liquidity and start earning a continuous economic return instantly. Through the borrowing operation, users can request crypto loans by locking deposited funds as collateral.
This article presents a general overview of the key points to consider when users interact with a DeFi lending protocol such as Folks Finance.
Lending, Deposit, and Interest Rate
Usually, the main page displays the crypto markets supported by the platform, where users can evaluate the different assets for the financial operations to be carried out.
In Folks Finance, the reference market is dedicated to the ASA (Algorand Standard Asset) tokens, based on Algorand’s Blockchain, chosen according to economic and technical requirements.
The first interaction that users have with DeFi lending protocols is the initial deposit. The deposited assets are collected in the relative market pool, and the protocol uses it as lending liquidity. Folks Finance utilizes the interest paid by the borrowers to pay the interest accrued by the lenders. The lending interest rate is calculated following the basic rules of supply and demand in the free market. This means that the interest rate depends on how much has been borrowed. The higher the demand for borrowing, the higher the lending interest.
The interest rates are ruled by mathematical laws, strictly related to the utilization ratio (U), which is the ratio between the total borrowed amount and the total liquidity of the pool. This ratio varies in a predetermined and adjustable range to ensure stability and security. Folks Finance sets the utilization ratio to control the interest growth: high values of U correspond to high rates and the protocol incentives deposits; low values of U correspond to low rates and the protocol incentives borrowings.
Borrowing, Collateral, and Loan-to-Value (LTV)
During the borrowing phase, DeFi lending protocols require that each loan be secured by collateral. Again, in Folks Finance, the collateral is an ASA token that can be any supported asset, whether it be a stablecoin or a volatile crypto asset.
In general, for each borrowing contract, what varies over time is the conversion rate between the asset representing the collateral and the borrowed asset. Based on the variation, Folks Finance allows two operations:
1. If the collateral value increases relative to the value of the borrowed capital, the user should be able to borrow more capital as the collateral covers more value.
2. If the collateral value decreases lower than the borrowed value, the user must add more f-tokens (the collateral tokens in Folks Finance) to keep the collateral value above the under collateralization threshold.
Considering the volatility of assets provided as collateral and, therefore, the risk of borrowers not repaying their loans, Folks Finance requires over-collateralizing their positions, guaranteeing the lenders’ safety. The percentage of capital that can be borrowed against collateralizing a specific asset is defined as the Loan-to-Value (LTV).
Stablecoin’s LTV is higher compared to the LTV of volatile cryptos.
Liquidation, Incentives, and Health Factor
The liquidation mechanism occurs when collateral’s value falls below the under-collateralization threshold. In this context, liquidators have the opportunity to buy the collateral at a discounted price.
Folks Finance safeguards its markets by strongly incentivizing liquidation. Essentially, the collateral (f-tokens) is sold to the liquidator for its actual value minus a penalty, representing the liquidator’s income. This operation is crucial for DeFi Lending protocols since, if a position is not liquidated promptly, the protocol risks losing unpaid loans.
The degree of risk of a position is evaluated by the health factor: an index that measures its state of health based on the collateral-asset borrowed pair. The lower the health factor, the more the position is at risk of liquidation.
Conclusion
Folks Finance, leveraging Algorand’s fast, scalable, low-cost, decentralized, and secure infrastructure, offers a unique DeFi protocol for lending, borrowing, and a liquidation mechanism.
Folks Finance allows users to maximize yield and return on their capital. Moreover, the protocol facilitates the control of their collaterals, thanks to LTV and Health Factor. Those indices aim to ensure maximum security on the user’s loan. The goal of the protocol is to offer flexible and attractive interest rates together with strong incentives for both the lenders and the borrower, creating a money market that can match the needs of both.
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