Quiz: Lending, Borrowing, and Yield

Multiple Choice

Question 1

Why does DeFi lending require overcollateralization?

(a) Because DeFi protocols charge higher interest rates than banks (b) Because there is no identity verification, credit scoring, or legal recourse — the collateral is the only protection against default (c) Because Ethereum transactions are slow and the extra collateral compensates for settlement delays (d) Because governance token holders voted to require it

Answer: (b). DeFi lending is permissionless and pseudonymous. The protocol cannot verify a borrower's identity, check their credit history, or pursue legal action in case of default. Overcollateralization ensures that the protocol can always recover its funds by seizing and selling collateral, regardless of who the borrower is.

Question 2

A borrower deposits $200,000 worth of ETH with a liquidation threshold of 82.5% and borrows $120,000 USDC. What is their health factor?

(a) 0.60 (b) 1.38 (c) 1.67 (d) 2.00

Answer: (b). Health Factor = (Collateral Value x Liquidation Threshold) / Debt = ($200,000 x 0.825) / $120,000 = $165,000 / $120,000 = 1.375, which rounds to 1.38.

Question 3

In a utilization-based interest rate model with a "kink," what happens to the borrow rate when utilization exceeds the optimal utilization rate?

(a) The borrow rate decreases to encourage more borrowing (b) The borrow rate remains constant at the kink level (c) The borrow rate increases sharply, following a steeper slope (Slope2) (d) The borrow rate resets to the base rate

Answer: (c). The kink model uses two slopes. Below optimal utilization, rates increase gradually (Slope1). Above optimal utilization, rates increase dramatically (Slope2, typically 10-50x steeper than Slope1). This sharp increase incentivizes repayment and new deposits, pulling utilization back toward optimal.

Question 4

Which of the following is TRUE about flash loans?

(a) Flash loans require 50% collateral, which is lower than normal loans (b) Flash loans must be repaid within 24 hours (c) Flash loans require no collateral because if repayment fails, the entire transaction reverts as if the loan never happened (d) Flash loans are only available to whitelisted addresses approved by governance

Answer: (c). Flash loans exploit the atomic nature of blockchain transactions. The loan is issued and must be repaid within the same transaction. If repayment does not occur, the transaction reverts entirely — from the blockchain's perspective, the loan never happened. The protocol's risk is zero, so no collateral is needed.

Question 5

A lending pool has the following parameters: Base Rate = 2%, Optimal Utilization = 80%, Slope1 = 6%, Slope2 = 120%. What is the borrow rate at 90% utilization?

(a) 8% (b) 20% (c) 68% (d) 128%

Answer: (c). Below the kink: Base Rate + (U_optimal / U_optimal) x Slope1 = 2% + 1.0 x 6% = 8% at the kink. Above the kink: 8% + ((0.90 - 0.80) / (1.0 - 0.80)) x 120% = 8% + (0.10/0.20) x 120% = 8% + 0.5 x 120% = 8% + 60% = 68%.

Question 6

During a liquidation on Aave with a 5% liquidation penalty and a 50% close factor, a liquidator repays $10,000 of a borrower's debt. How much collateral does the liquidator receive?

(a) $9,500 (b) $10,000 (c) $10,500 (d) $15,000

Answer: (c). The liquidator repays $10,000 of debt and receives collateral worth $10,000 x 1.05 = $10,500. The 5% liquidation penalty is a bonus for the liquidator (and a cost to the borrower), incentivizing participation in the liquidation mechanism.

Question 7

What is the primary difference between Compound's cTokens and Aave's aTokens?

(a) cTokens earn interest through an increasing exchange rate; aTokens earn interest through balance rebasing (b) cTokens can be transferred; aTokens cannot (c) cTokens represent collateral; aTokens represent debt (d) cTokens are governance tokens; aTokens are receipt tokens

Answer: (a). With cTokens (Compound), you receive a fixed number of tokens at deposit, and the exchange rate increases over time as interest accrues. With aTokens (Aave), you receive tokens equal to your deposit, and your balance literally increases over time (rebasing). Both represent the same economic claim — your deposit plus accumulated interest — but use different accounting mechanisms.

Question 8

A protocol has annual revenue of $10M from fees, distributes $80M in token emissions per year, and has $2B in TVL. What is its real yield?

(a) 4.5% (b) 0.5% (c) -3.5% (d) -0.5%

Answer: (c). Real Yield = (Protocol Revenue - Token Emissions) / TVL = ($10M - $80M) / $2B = -$70M / $2B = -3.5%. The negative real yield means the protocol is distributing far more value in token emissions than it generates in revenue, making the yield unsustainable.

Question 9

Which of the following is NOT a legitimate use case for flash loans?

(a) Arbitraging price differences between two decentralized exchanges (b) Swapping collateral type on a lending protocol without closing the position (c) Earning staking rewards over a 30-day lock-up period (d) Self-liquidating a position to avoid the liquidation penalty

Answer: (c). Flash loans must be repaid within the same transaction (the same block). A 30-day staking program requires the tokens to be locked for 30 days, which is impossible to complete within a single atomic transaction. The other three options — arbitrage, collateral swaps, and self-liquidation — can all be completed within one transaction.

Question 10

What event does the term "Black Thursday" refer to in DeFi history?

(a) The collapse of Terra/Luna in May 2022 (b) The March 12, 2020 market crash where MakerDAO's liquidation system failed, leading to zero-bid auctions and millions in bad debt (c) The Euler Finance hack that drained $197 million (d) The launch of Compound's COMP token that started DeFi Summer

Answer: (b). On March 12, 2020, a rapid ETH price crash triggered massive liquidations on MakerDAO. Gas prices spiked so high that most liquidation bots could not operate, and some vaults were liquidated in zero-bid auctions — meaning liquidators acquired the collateral for free, creating approximately $6 million in bad debt (protocol losses).

True/False

Question 11

The supply rate in a DeFi lending pool is always lower than the borrow rate.

Answer: True. The supply rate = borrow rate x utilization rate x (1 - reserve factor). Since both the utilization rate and (1 - reserve factor) are less than 1, the supply rate is always lower than the borrow rate. This makes intuitive sense: not all deposited funds are borrowed (diluting the yield across all depositors), and the protocol takes a cut (reserve factor).

Question 12

A health factor of 1.5 means the borrower's position is 50% overcollateralized relative to the liquidation threshold.

Answer: True. A health factor of 1.5 means that the weighted collateral value is 1.5 times the total debt. The collateral would need to lose approximately 33% of its value (1 - 1/1.5 = 0.33) before the health factor reaches 1.0 and the position becomes liquidatable.

Question 13

Flash loans are risk-free for the lending protocol because failed repayment causes the entire transaction to revert.

Answer: True (from the protocol's lending pool perspective). If the flash loan is not repaid, the transaction reverts and the protocol's funds are never transferred. However, the protocol may still face indirect risks — for example, flash loans can be used to manipulate oracles or exploit vulnerabilities in other parts of the protocol, causing losses through mechanisms other than direct non-repayment.

Question 14

Yield farming always generates positive returns for participants.

Answer: False. Yield farming carries significant risks: smart contract exploits can drain deposited funds, token emissions that form the bulk of "yield" can decrease in value faster than they are earned, liquidation of leveraged positions can result in losses, and gas costs for frequent harvesting and rebalancing can erode returns. Many yield farmers — particularly those who entered popular farms late — lost money during the 2021-2022 downturn.

Question 15

Compound v3 simplified its design by allowing each market to have only a single borrowable asset.

Answer: True. Compound v3 (Comet) uses a single-asset lending model. Each deployment focuses on one borrowable asset (initially USDC, later WETH). Multiple assets can serve as collateral, but borrowers can only borrow the one designated asset. This reduces the attack surface by eliminating cross-asset risk vectors that existed in Compound v2.

Short Answer

Question 16

Explain the concept of "cascading liquidations" and describe two factors that can make them worse during a market crash.

Expected Answer: Cascading liquidations occur when the liquidation of one position creates selling pressure that pushes prices lower, triggering liquidations of other positions, which creates more selling pressure, and so on in a positive feedback loop. Two factors that worsen cascading liquidations are: (1) gas price spikes during high-demand periods, which can make smaller liquidations unprofitable and delay the clearing of undercollateralized positions; and (2) concentrated collateral types, where many borrowers use the same asset (e.g., ETH) as collateral, so all positions become liquidatable simultaneously during a crash in that single asset.

Question 17

A DeFi protocol advertises a 15% APY on stablecoin deposits. Describe three questions you would ask to determine whether this yield is sustainable.

Expected Answer: (1) What percentage of the 15% comes from borrower interest payments (real yield) versus token emissions (inflationary yield)? (2) What is the protocol's total annual revenue compared to total annual token emissions — is it revenue-positive or emissions-dependent? (3) What is the emission schedule — are token distributions declining over time, or are they flat/increasing, suggesting the current rate is unsustainable?

Other acceptable answers include: What is the token's price trend (declining prices suggest farm-and-dump dynamics)? Who are the borrowers and what are they willing to pay for? Is the TVL growing or shrinking? What is the protocol's fully diluted valuation relative to revenue?

Question 18

Explain why Aave v3's "Efficiency Mode" (E-mode) can safely allow higher LTV ratios for certain asset pairs, and give one example of an asset pair that would qualify.

Expected Answer: E-mode allows higher LTV ratios (up to 97%) for asset pairs that are highly correlated in price — meaning the collateral and borrowed asset tend to move together. Because both sides of the position move in the same direction, the risk of the collateral losing value relative to the debt is much lower than for uncorrelated assets. Example: stETH (staked ETH) as collateral to borrow WETH — both track the price of ETH, so the collateral-to-debt ratio remains stable even during market volatility. Another example: USDC as collateral to borrow DAI — both are stablecoins pegged to $1.

Question 19

Describe the difference between a flash loan arbitrage and a flash loan exploit. Why is the distinction legally and ethically important?

Expected Answer: A flash loan arbitrage exploits price discrepancies between markets — buying cheap on one exchange and selling high on another. It profits from market inefficiency and actually improves market efficiency by aligning prices. A flash loan exploit uses borrowed funds to manipulate prices, exploit smart contract vulnerabilities, or drain protocol funds through unintended behavior. The distinction matters legally because arbitrage is generally considered legitimate market activity, while manipulation and exploitation of code vulnerabilities may constitute fraud or market manipulation (as demonstrated by the Eisenberg/Mango Markets prosecution). Ethically, arbitrage creates value (more efficient markets) while exploits extract value (harming depositors and protocol users).

Question 20

A lending pool has a reserve factor of 20%. Explain what this means and how it creates a tension between protocol sustainability and user yield.

Expected Answer: The reserve factor is the percentage of borrower interest payments that goes to the protocol's treasury rather than being distributed to suppliers. A 20% reserve factor means that for every $100 in interest paid by borrowers, $80 goes to suppliers (as their yield) and $20 goes to the protocol. This creates a tension: a higher reserve factor gives the protocol more revenue for development, bug bounties, insurance funds, and governance operations — improving long-term sustainability. But a higher reserve factor also reduces the supply rate, making the protocol less competitive for depositors who can move their funds to protocols with lower reserve factors. The governance challenge is finding the reserve factor that maximizes long-term protocol health without driving away suppliers.