Industry Background and Current State

The introduction of Web3 technology has brought revolutionary changes to the financial sector, particularly in the lending industry. Traditional lending models rely on centralized financial institutions, which are often inefficient, lack transparency, and have high entry barriers. In contrast, Web3 lending leverages decentralization, transparency, and automation to reshape lending relationships and provide more flexible, efficient, and inclusive financial services. Through blockchain and smart contracts, Web3 lending automates loan processes, reducing counterparty risks and enhancing capital security. Transactions on the blockchain are public and transparent, increasing user trust and mitigating information asymmetry risks. Smart contracts automatically execute lending agreements, including collateral management, interest calculation, and liquidation, improving efficiency and reducing human errors and moral hazards.

As a core component of decentralized finance (DeFi), the Web3 lending market is often measured by its size and activity levels, both of which serve as key indicators of market health. During the DeFi boom from 2021 to 2022, the lending market saw TVL (Total Value Locked) surge to historic highs, driven by high-yield liquidity mining, low interest rates, and speculative enthusiasm. However, as global monetary policies tightened (such as the Federal Reserve’s interest rate hikes) and the crypto market entered a bear cycle, leveraged positions unwound, leading to a decline in TVL. Over the past three years, major black swan events such as the UST/LUNA collapse and the FTX crisis have exposed vulnerabilities in overcollateralized models, particularly their reliance on single-asset collateral (e.g., ETH). These crises shook market confidence, resulting in stagnant TVL growth. In response, leading protocols like Aave and Compound accelerated innovation, introducing new lending mechanisms. After 2023, the rise of real-world asset (RWA) tokenization and the expansion of Bitcoin Layer2 ecosystems injected fresh momentum into the lending market. With the full implementation of the MiCA regulation in 2024, compliance has become a fundamental requirement for mainstream lending protocols.

As of March 9, 2025, the total value locked (TVL) in the Web3 lending sector has reached approximately $41.7 billion. This reflects the industry’s transition from rapid, unstructured growth to a more sophisticated operational model, alongside increasing user trust in decentralized lending platforms. It also highlights the expanding capital base of the market, signaling a new phase of growth driven by both efficiency and security.

Moreover, total outstanding loans stand at around $18.6 billion, demonstrating that borrowing activity remains strong and demand for decentralized lending continues to thrive.

Types of Lending Models

There are various lending models in the Web3 lending sector. This article primarily introduces overcollateralized lending, uncollateralized (credit) lending, flash loans, and RWA (real-world asset) lending.

Overcollateralized Lending

In the overcollateralized lending model, borrowers must provide crypto assets worth more than the loan amount as collateral to ensure loan security. This model is widely used in decentralized finance (DeFi) platforms like MakerDAO, Compound, and Aave. The mechanism works as follows: borrowers deposit a certain amount of crypto assets as collateral on the platform. Due to the high volatility of crypto prices, platforms usually require overcollateralization, meaning the value of the collateral must exceed the loan amount to reduce risk. Borrowers can obtain a corresponding amount of crypto or stablecoins based on the collateral value. For example, on MakerDAO, users collateralize ETH to generate DAI stablecoins. Borrowers must pay interest based on the platform’s set rates. If the collateral value drops below the platform’s minimum collateralization ratio, the system automatically liquidates part or all of the collateral to ensure loan solvency.

Uncollateralized (Credit) Lending & Flash Loans

In the uncollateralized (credit) lending model, borrowers do not need to provide traditional collateral. Instead, loan approval depends on their credit history or community reputation. Projects like TrueFi use a Decentralized Autonomous Organization (DAO) voting and credit rating system to evaluate borrower qualifications before determining loan amounts and interest rates. Borrowers submit credit proof or third-party-backed documents, which are then reviewed by community members before loan approval. The main advantage of credit-based lending is that it lowers borrowing barriers, making it accessible to users who lack sufficient collateral, while also improving capital efficiency. However, its success relies on a robust and transparent credit evaluation system to accurately assess borrower credibility and control default risk.

Flash loans are a unique type of uncollateralized loan that leverages the atomic properties of blockchain transactions. They allow users to borrow large sums within a single transaction, use the funds for arbitrage, cross-platform liquidation, or other operations, and repay the loan before the transaction ends. If the loan is not repaid within the same transaction, the entire process is automatically reversed, ensuring high security for lenders.

Flash loans are commonly used for:

• Arbitrage trading by capitalizing on price differences across platforms
• Providing liquidity for liquidations
• Optimizing capital flows in cross-chain operations

Despite requiring no traditional collateral, flash loans demand advanced transaction logic and high contract security, as any failure in execution results in a failed transaction. Overall, flash loans offer DeFi users a highly efficient, instant, and flexible funding mechanism, fostering further financial innovation.

RWA (Real-World Asset) Lending

Real-world asset (RWA) lending refers to tokenizing real-world assets—such as real estate, invoices, and accounts receivable—and introducing them into blockchain platforms as loan collateral. This model aims to bridge traditional financial assets with DeFi, expanding the applications of crypto lending.

The process works as follows:

1. Real-world assets are tokenized using legal and technical frameworks to create blockchain-based representations of ownership or revenue rights.
2. Users collateralize tokenized RWAs on DeFi platforms to borrow crypto or stablecoins.
3. Platforms set interest rates and liquidation mechanisms based on the nature and market conditions of the collateral to ensure fair and secure lending.

For example, the Centrifuge platform tokenizes invoices and accounts receivable, providing new financing channels for SMEs while offering stable returns for investors. Its lending platform, Tinlake, allows users to borrow against RWA collateral, while investors can fund these loans to earn yields.

As of March 9, 2025, the total value locked (TVL) in the RWA sector has reached $17 billion, excluding stablecoins and covering private credit and tokenized U.S. Treasury-backed assets. This indicates accelerating integration between blockchain and traditional finance.

Currently, private credit dominates 70% of the RWA market, showing that institutional investors are increasingly recognizing on-chain credit markets. More corporations and funds are now using blockchain for asset management and financing. Meanwhile, 21% of the RWA market is composed of tokenized U.S. Treasury-backed assets, highlighting the growing demand for low-risk, compliant investment tools. Projects like Ondo Finance have introduced tokenized Treasury products (e.g., OUSG), enabling institutions and individuals to hold U.S. Treasuries directly on-chain, improving accessibility and liquidity.

This trend suggests that RWA tokenization is moving beyond proof-of-concept and into real-world application, with DeFi becoming an integral part of global financial markets. As more traditional financial institutions enter this space and regulatory policies (such as MiCA) become clearer, the RWA market’s TVL is expected to grow further, shaping a more mature on-chain financial ecosystem.

Case Study of Leading Projects

Overcollateralized Lending

MakerDAO

MakerDAO is one of the earliest projects to integrate decentralized lending with the stablecoin concept, with its core mechanism based on overcollateralization to generate the DAI stablecoin. On the MakerDAO platform, users create Vaults (formerly called CDPs, or Collateralized Debt Positions) and deposit ETH or other supported crypto assets as collateral into smart contracts. The system requires that the collateralized assets must exceed the value of the DAI issued, typically by at least 150% or more, ensuring a sufficient safety margin in case of market fluctuations. Each Vault has a liquidation threshold—if the collateral value drops and causes the collateralization ratio to fall below this threshold, the system automatically triggers liquidation. This involves auctioning part or all of the collateral to repay the outstanding debt, thereby ensuring effective risk control in lending. Additionally, MakerDAO sustains its system by charging Vault holders a “stability fee”, which acts as interest on borrowed DAI. These fees are denominated in DAI and are adjusted through MakerDAO’s governance mechanism, where MKR token holders vote on key parameters, such as minimum collateral ratios, stability fees, and debt ceilings. Overall, MakerDAO’s design focuses on maintaining DAI’s stability and ensuring decentralized governance, enabling the system to self-regulate and recover even during extreme market volatility.

Aave

Aave is a decentralized lending platform based on liquidity pools, utilizing a dual banking-like model for deposits and loans. Users who deposit various crypto assets on Aave receive aTokens (e.g., aETH, aDAI), which represent their share of the deposit pool and automatically accrue interest over time. Borrowers must provide collateral before borrowing, and their loan amount is determined by the loan-to-value (LTV) ratio set by the platform. Aave’s interest rate model is dynamic, adjusting in real-time based on supply and demand, which encourages capital to flow into high-demand asset pools. If a borrower’s collateralization ratio falls below the platform’s safety threshold, the system automatically triggers liquidation to protect the liquidity pool. In addition to traditional overcollateralized lending, Aave introduced flash loans, allowing users to borrow without collateral within a single transaction. If the borrowed funds are not repaid before the transaction ends, the entire process reverts, ensuring zero risk for lenders. This feature has significantly expanded arbitrage, refinancing, and liquidity optimization use cases. Aave also supports credit delegation, allowing users to authorize others to borrow using their credit limit without transferring actual assets, further enhancing the protocol’s flexibility and capital efficiency. Governance is controlled by AAVE token holders, who propose and vote on protocol upgrades.

Aave holds a leading position in the Web3 lending market, with a total value locked (TVL) of $29.9 billion, accounting for 72% of the lending market share. The total outstanding loan volume stands at $11.6 billion, representing 62% of the market share. These figures highlight Aave’s dominance in both capital scale and lending activity, cementing its role as a top-tier Web3 lending protocol.

Aave has evolved through three major versions (V1, V2, and V3), continuously improving lending efficiency, capital optimization, and security:

• V1: The initial version, which introduced basic overcollateralized lending but lacked advanced features.
• V2: Introduced flash loans, collateral swaps, and interest rate switching, enhancing flexibility and liquidation security.
• V3: Improved cross-chain interoperability, optimized capital efficiency, and introduced more refined risk management strategies, enabling smoother and safer fund transfers across networks.

V3 also enhanced smart contract architecture, reducing transaction costs and improving the user interface, making DeFi lending more open, flexible, and secure.

Compared to previous versions, V3 significantly improved functionality, security, and efficiency, leading to a surge in user adoption. Key advantages of V3 include:

• Lower transaction fees
• Higher capital efficiency
• Stronger cross-chain capabilities

These improvements have dramatically enhanced user experience, making V3 the preferred choice for borrowing and lending. As of March 9, 2025, 98% of Aave users are now operating on V3, demonstrating its dominance and strong adoption in the DeFi lending market.

Compound

Compound is another well-known overcollateralized lending protocol, with a core concept of pooling all deposited assets into a shared liquidity pool, where users’ deposit rights are represented by cTokens. When users deposit assets into Compound, they receive corresponding cTokens (e.g., cETH, cDAI), which not only represent their deposit share but also increase in value over time as interest accumulates. Compound’s borrowing mechanism follows the standard overcollateralization model, where users must provide collateral at a platform-defined ratio to secure loans. The loan amount is determined by the collateral factor, and if the collateralization ratio falls below the safety threshold, the smart contract automatically triggers liquidation, selling part of the collateral at a discount to recover the outstanding loan. The interest rate model in Compound is algorithm-driven, adjusting automatically based on the utilization rate of the asset pool. This incentivizes capital inflow into liquidity pools while also restricting excessive borrowing during periods of high demand. Compound also introduced the governance token COMP, which allows holders to propose and vote on key protocol parameters, such as interest rate models and liquidation penalties. Similar to Aave, Compound aims to automate lending and risk management, but its primary focus is on simplifying user experience and maximizing capital efficiency. The cToken model allows depositors to seamlessly use their deposit holdings across the DeFi ecosystem, providing greater liquidity and flexibility.

Uncollateralized (Credit) Lending and Flash Loans

TrueFi

TrueFi is a credit-based lending platform, also known as uncollateralized lending, that provides loans without requiring traditional collateral. Instead of relying on asset deposits, TrueFi determines a borrower’s creditworthiness through credit ratings and community governance, allowing for loan issuance. On TrueFi, borrowers do not need to deposit crypto as collateral; instead, they submit loan applications and undergo credit evaluations to determine their loan limits. TrueFi’s credit assessment model does not solely rely on on-chain data but also considers historical transaction records, identity verification, and even external credit information. The evaluation process is governed by TRU token holders, who review applications and vote on loan conditions.

The loan approval process follows these steps:

1. The borrower submits a loan request with relevant financial and identity documentation to prove their creditworthiness.
2. The protocol’s credit rating system conducts a preliminary evaluation using past repayment history, community reputation, and other relevant factors.
3. The credit committee or TRU token holders review the credit score and vote on loan approval, loan amount, interest rate, and repayment terms.

Through this method, TrueFi enables creditworthy users to access financing without requiring them to provide traditional collateral.

TrueFi’s credit-based lending model offers significant advantages. It lowers borrowing barriers, enabling users without high-value crypto collateral to access liquidity. Additionally, since loan terms are determined through community governance, the protocol ensures transparency and decentralization. However, uncollateralized lending also carries credit default risks. To mitigate these risks, TrueFi has implemented a dynamic credit rating system, adjustable interest rates, and default penalty mechanisms. For example, if a borrower defaults, the platform may impose reputation score reductions or suspend their loan access as a form of risk compensation. TrueFi continuously improves its credit data system, aiming to enhance the accuracy and fairness of its credit evaluations.

Aave

Apart from overcollateralized lending, Aave’s flash loans are one of its most significant lending innovations. Unlike traditional lending models, Aave’s flash loans allow users to borrow funds without collateral within a single transaction. However, the borrowed funds must be used and repaid within the same transaction—otherwise, the entire transaction is automatically reverted. This mechanism leverages the atomic nature of blockchain transactions, ensuring that all operations within the transaction must succeed; otherwise, the entire state is rolled back to the beginning of the transaction, guaranteeing absolute security of platform funds.

Flash loans follow these key steps:

1. The user calls Aave’s flash loan interface to request a loan.
2. The smart contract immediately transfers the requested funds to the user.
3. The user executes specific operations within the same transaction, such as arbitrage, cross-platform liquidation, or refinancing.
4. Before the transaction ends, the smart contract verifies whether the loan principal and fees have been repaid.
5. If repayment conditions are not met, the entire transaction is reverted, making all actions invalid.

This design enables Aave to offer millions of dollars in short-term uncollateralized funds without exposing platform assets to risk, as all risks are mitigated by the atomic transaction mechanism.

Flash loans have a wide range of applications, including:

• Arbitrage Trading – Traders can take advantage of price differences between different decentralized exchanges (DEXs) by buying at a lower price and selling at a higher price within a single transaction.
• Cross-Platform Liquidation – Users can leverage flash loans to optimize liquidity, quickly liquidating positions and capturing market opportunities.

In addition to flash loans, Aave introduced a credit delegation feature, where users can authorize their credit limits for others to use. While this feature is not classified as a flash loan, it enhances borrowing flexibility and capital efficiency within DeFi.

At its core, Aave still relies on an overcollateralized lending model. Depositors receive aTokens that automatically accrue interest over time. Borrowers must maintain sufficient collateral ratios to borrow funds. If collateral ratios fall too low, Aave automatically triggers liquidation. Flash loans serve as an innovative extension of Aave’s existing structure, demonstrating the flexibility and innovation of blockchain-based financial applications. Since flash loans are powered by smart contracts with rigorous security checks, they ensure that platform funds remain secure even in extreme market conditions.

RWA (Real-World Asset) Lending

Ondo Finance

Ondo Finance is committed to connecting traditional financial products with the DeFi ecosystem. Its core goal is to tokenize real-world assets (RWAs) such as U.S. Treasury bonds and money market funds, bringing stable-yield financial products onto the blockchain. Ondo Finance collaborates with legally authorized financial institutions to package and tokenize traditional off-chain financial assets. During this process, asset issuers convert physical bonds or fund shares into digital tokens, which represent ownership or revenue rights and hold legal validity, allowing them to be freely traded on the blockchain.

In terms of specific operations, Ondo Finance provides users with a range of tokenized bond products. For example, the platform may launch bond fund products based on U.S. short-term Treasury securities. After completing strict KYC/AML verification, users can purchase corresponding bond tokens through the platform. Once purchased, these tokens can not only be traded on secondary markets but also used for lending or staking, allowing users to earn stable interest income. The platform sustains its business model by charging a percentage of management fees and service fees. At the same time, it adopts a decentralized governance mechanism (via the platform’s native token), enabling community members to participate in key decision-making processes. Recently, Ondo Finance’s total value locked (TVL) surpassed $1 billion, demonstrating strong market recognition of its innovative model. Ondo Finance’s core advantage lies in digitizing low-risk, stable-yield traditional financial assets and integrating them into the DeFi ecosystem. This allows investors to enjoy blockchain’s transparency and low transaction costs while still achieving stable returns similar to traditional finance. However, this model also faces challenges, including cross-chain interoperability, regulatory compliance, and external market fluctuations. To ensure long-term sustainability, Ondo Finance needs to allocate more resources to risk management and asset auditing.

Centrifuge

Centrifuge focuses on tokenizing real-world assets (RWAs)—such as accounts receivable, invoices, and real estate lease contracts—to introduce new forms of collateral into blockchain-based lending markets. Its core product, Tinlake, utilizes a hybrid on-chain and off-chain approach, helping asset issuers convert traditional assets into digital tokens for financing within the DeFi ecosystem.

The operational mechanism of Centrifuge works as follows:

1. Asset Issuance & Tokenization

   • Asset issuers first conduct due diligence and legal verification on real-world assets such as future cash flows and accounts receivable.
   • These assets are then tokenized via the Centrifuge platform, creating digital asset tokens that can be traded on the blockchain.
   • These tokens are deposited into a dedicated asset pool, forming a collateral pool.

2. Liquidity Provision & Yield Generation

   • Liquidity providers (LPs) can supply funds to this asset pool via Tinlake.
   • Smart contracts manage lending operations, enabling LPs to earn expected returns based on asset performance.

3. Risk Management via Tranching

   • Centrifuge implements a tiered collateral and risk segmentation mechanism, assigning different priority levels to risk exposure within the asset pool.
   • Lower-risk tranches receive priority repayment rights, while higher-risk tranches bear greater potential losses.
   • This structure effectively distributes risk while allowing investors with different risk preferences to select suitable options.

In addition, Centrifuge integrates centralized KYC/AML processes. It conducts regular third-party audits to ensure the compliance and authenticity of off-chain assets, thereby enhancing trust in the entire system. The platform uses smart contracts to automate key functions such as asset tokenization, fund transfers, and liquidation, ensuring that the lending process remains transparent and efficient. Through this model, Centrifuge provides a new financing channel for traditional asset holders and introduces a broader range of low-volatility, stable-yield assets into the DeFi ecosystem.

Risk and Regulatory Considerations

Smart Contract Vulnerabilities

Smart contracts are the core of decentralized finance (DeFi) platforms, automatically executing transactions and protocols based on predefined code. However, their complexity and potential vulnerabilities make them prime targets for attackers. Historically, several DeFi projects have suffered massive losses due to smart contract flaws.

• Mango Markets Attack (October 2022) – $116 million loss

  • Attackers manipulated the price of the Mango token, creating price discrepancies across exchanges.
  • This triggered forced liquidations, eventually draining the protocol’s funds.

• Euler Finance Exploit (March 2023) – $197 million loss

  • Hackers exploited a flash loan vulnerability within Euler Finance’s smart contract.
  • By abusing the “donation” function, they bypassed liquidation checks and repeatedly borrowed funds, draining liquidity pools.
  • Although Euler’s team recovered 90% of the stolen funds through on-chain negotiations, the event exposed the hidden risks of complex smart contract logic.

• Poly Network Cross-Chain Bridge Hack (July 2023) – $340 million loss

  • Attackers stole private keys and forged blockchain signatures to bypass smart contract permissions.

These incidents have accelerated advancements in DeFi security, leading to:

• CertiK’s AI-powered Skynet 2.0, introduced in 2024, monitors blockchain transactions in real time and has already prevented over 1,200 potential attacks.

These cases highlight the critical need for rigorous smart contract audits and continuous security monitoring to mitigate potential vulnerabilities and cyber threats.

Market Liquidity Risk and Liquidation Risk

Market liquidity risk and liquidation risk are major challenges faced by DeFi lending platforms. Liquidity crises can be triggered by market downturns, increased token volatility, or large withdrawals, leading to price slippage, forced liquidations, or collateral shortages, which put significant pressure on protocols. For example, in June 2023, Curve Finance suffered an exploit due to a stablecoin pool smart contract vulnerability, causing the CRV token to plummet by 70%. As a result, the value of CRV collateral in on-chain lending protocols (such as Aave and Fraxlend) dropped significantly, triggering a $1 billion liquidation risk. In an effort to save the situation, Curve’s founder was forced to sell a large number of CRV tokens, nearly causing a cascading liquidation crisis. The issue was ultimately resolved through Oasis.app’s emergency debt buyback feature, which provided an OTC (over-the-counter) solution to stabilize the market.

Additionally, the success of the liquidation process largely depends on liquidators, who must monitor lending protocols in real time and execute liquidations swiftly. If the value of seized collateral is too close to the outstanding debt, the position risks falling into bad debt. Setting robust and up-to-date risk parameters—such as loan-to-value (LTV) ratios, collateralization ratios (CR), and liquidation buffers—is crucial to managing this risk. A case in point occurred in March 2024, when Solana-based lending protocol Kamino faced a $120 million liquidation risk due to extreme price fluctuations in the Jito (JTO) token. Network congestion on Solana prevented some liquidation bots from executing on time, leading to $8 million in bad debt. To prevent similar issues in the future, Kamino introduced a “dynamic liquidation premium” mechanism, which adjusts incentives in real time based on on-chain gas fees, improving liquidation efficiency.

Regulatory Challenges

The decentralized nature of DeFi platforms presents significant regulatory challenges. Many DeFi projects lack clear oversight from regulatory authorities, resulting in legal and compliance risks for users. Different countries have varying regulatory stances on cryptocurrencies and DeFi, meaning that policy changes can significantly impact DeFi operations.

For example:

• China’s 2021 crackdown on cryptocurrencies led to a sharp decline in trading volumes across multiple DeFi projects, with users facing asset lock-ups and liquidity loss risks.
• The U.S. Securities and Exchange Commission (SEC) has disputes over the classification of certain DeFi tokens, creating uncertainty for projects in terms of regulatory compliance.
• The SEC lawsuit against Ripple highlighted the challenges regulators face when applying traditional securities laws to digital assets.

Additionally, non-compliance with DeFi services is a major concern:

• The anonymous nature of DeFi makes traditional KYC (Know Your Customer) and AML (Anti-Money Laundering) regulations difficult to enforce.
• This allows instant and anonymous layering of funds, increasing the risk of financial crimes and sanction evasion.

• If DeFi service providers fail to:

  • Register with appropriate regulatory bodies
  • Implement and maintain effective AML and counter-terrorist financing (CFT) measures
  • Comply with sanctions laws

  Then, criminal actors could exploit DeFi platforms to bypass U.S. and UN sanctions.

One of DeFi’s biggest challenges is enforcing KYC and AML compliance without sacrificing user privacy.

With the full implementation of the Markets in Crypto-Assets (MiCA) regulation in Europe in 2024, the European crypto market will have a clearer regulatory framework.

• DeFi platforms will need to improve compliance and transparency to meet new regulatory standards.
• MiCA requires crypto asset service providers (CASPs) to obtain licenses and adhere to strict operational and capital requirements.
• While some DeFi protocols may bypass these rules, platforms interacting with traditional finance will likely be affected.

MiCA also emphasizes stablecoin regulation, which could impact DeFi lending platforms that rely on stablecoins.

Conclusion

The Web3 lending market has experienced rapid growth in recent years. Despite various challenges, its decentralized, transparent, and efficient nature gives it tremendous potential in the financial sector. As technology advances and regulatory frameworks gradually improve, Web3 lending is expected to strike a better balance between efficiency and security, leading to a new growth cycle.