DeFi Lending Protocols: A Comparison of Aave, Compound, and MakerDAO

Introduction

Decentralized finance (DeFi) has revolutionized the lending and borrowing industry by removing intermediaries and providing permissionless access to financial services. Unlike traditional banks that require credit checks, collateral evaluations, and long approval processes, DeFi lending protocols allow users to lend and borrow assets directly through smart contracts.

Among the most popular DeFi lending platforms, Aave, Compound, and MakerDAO stand out as the leading protocols. Each of these platforms offers unique mechanisms, governance structures, and interest rate models that cater to different user needs. Understanding how they compare helps users maximize returns and minimize risks when engaging with decentralized lending markets.

This article provides a detailed breakdown of Aave, Compound, and MakerDAO, focusing on how they work, their advantages, and key differences.

1. How DeFi Lending Works

The Role of Smart Contracts in Lending

Traditional lending involves banks acting as intermediaries to facilitate loans. They assess borrower creditworthiness, set interest rates, and manage repayment terms. In DeFi lending, smart contracts replace banks by automating these functions. Borrowers provide collateral in the form of cryptocurrency, and lenders deposit assets into liquidity pools to earn interest.

DeFi lending protocols use algorithmic interest rates, which adjust dynamically based on supply and demand. If borrowing demand increases, interest rates rise to incentivize more liquidity providers. Conversely, when supply is abundant and borrowing is low, rates decrease to attract borrowers.

Overcollateralization in DeFi Lending

Because DeFi loans are trustless, protocols require borrowers to deposit collateral worth more than the amount they borrow. This practice, called overcollateralization, protects lenders by ensuring the loan is covered even if the borrower defaults. However, it also limits accessibility since users must hold significant assets to participate in DeFi lending.

For example, if a borrower wants to take out a $5,000 loan in USDC, they may need to deposit $7,500 worth of ETH as collateral. If the collateral value drops below a certain threshold, liquidation occurs, and the borrower’s assets are sold to repay the loan.

2. Aave: Features and Benefits

Overview of Aave

Aave is one of the most widely used DeFi lending platforms, offering a broad range of assets for lending and borrowing. Initially launched on Ethereum, Aave has expanded to multiple blockchains, including Avalanche, Polygon, and Optimism.

Key features of Aave include:

• Flash loans – Unsecured loans that must be repaid within the same transaction block.
• Interest rate switching – Users can switch between stable and variable interest rates.
• Liquidity mining – Lenders earn additional rewards in AAVE tokens.

Aave’s flexible interest rate model makes it attractive for both borrowers and liquidity providers.

How Aave Handles Liquidations

To prevent bad debt, Aave automatically liquidates borrower collateral when its value falls below a set collateralization ratio. Liquidators receive a reward for covering the debt, ensuring that the protocol remains solvent.

For example, if a borrower deposits ETH as collateral and its value drops below the required collateral ratio, Aave executes a liquidation, repaying the debt using the borrower’s locked assets.

3. Compound: Features and Benefits

Overview of Compound

Compound is a DeFi lending protocol that operates through an autonomous interest rate algorithm. Unlike Aave, which offers multiple lending options, Compound provides a streamlined approach where users deposit assets into a liquidity pool and earn interest based on market demand.

Key features of Compound include:

• Algorithmic interest rates – Supply and demand automatically adjust rates without manual intervention.
• cTokens – Users receive cTokens when depositing assets, which accrue interest over time.
• Governance by COMP holders – Token holders vote on protocol updates and fee adjustments.

How Compound Handles Interest Rates

When a user deposits assets into Compound, they receive an equivalent amount of cTokens. For example, if they deposit USDC, they receive cUSDC. These tokens increase in value as interest accumulates, meaning users do not need to manually claim their earnings.

Borrowers, on the other hand, pay interest based on real-time market conditions. When borrowing demand increases, interest rates rise, making loans more expensive. When demand drops, borrowing costs decrease.

4. MakerDAO: Features and Benefits

Overview of MakerDAO

Unlike Aave and Compound, MakerDAO focuses primarily on generating the DAI stablecoin through collateralized debt positions (CDPs). Users lock up crypto assets as collateral in Maker Vaults and mint DAI, which maintains a soft peg to the U.S. dollar.

Key features of MakerDAO include:

• DAI stablecoin minting – Users generate DAI by locking ETH, WBTC, or other assets as collateral.
• Decentralized governance – MakerDAO governance token holders vote on risk parameters and interest rates.
• Stability fees and liquidation penalties – Ensure the solvency of the DAI system.

MakerDAO plays a vital role in DeFi by providing a decentralized, non-custodial stablecoin that users can borrow against without relying on fiat-based collateral.

How MakerDAO Handles Liquidations

If a borrower’s collateral falls below the required threshold, MakerDAO triggers an auction to sell the locked assets and recover the outstanding DAI debt. This mechanism ensures DAI remains fully backed by assets, preventing instability in the system.