LTV in crypto lending: what is it and how is it calculated?

What is LTV in cryptocurrency?

Decentralized protocols such as Aave, Morpho, and Compound allow users to borrow funds against cryptocurrency collateral.

However, the value of the cryptocurrency used as collateral may decline due to market fluctuations. At the same time, the outstanding debt gradually increases as interest accrues. As a result, the debt may approach the collateral's value to the point that the pledged cryptocurrency is automatically sold to repay the loan.

A special metric called LTV (Loan-to-Value) is used to monitor this situation.

What is LTV in cryptocurrency?

LTV (Loan-to-Value) is a metric that represents the ratio of the loan amount to the current market value of the cryptocurrency used as collateral. It is expressed as a percentage and shows how much of the collateral's value the borrower's outstanding debt represents.

For example, if the collateral is worth $1,000 and the loan amount is $500, the LTV is 50%. LTV in cryptocurrency serves as a risk indicator for lending positions: the higher the ratio, the greater the risk that the borrower may lose their collateral.

LTV in lending is also often referred to as the collateralization ratio. LTV in crypto is a dynamic metric that depends on volatility, meaning the degree of price fluctuations in cryptocurrencies.

Why is LTV important in cryptocurrency lending?

First, LTV gives borrowers up-to-date information on the status of their lending positions, helping them manage the risk of potential losses. LTV in DeFi serves as a risk management indicator, allowing borrowers to assess how much room they have before their collateral becomes subject to liquidation.

The second reason relates to the specific characteristics of lending in DeFi. Unlike traditional banks, decentralized lending protocols do not assess borrowers' creditworthiness based on their income, credit history, or other financial indicators. Instead, collateral is the primary way lenders protect themselves against potential losses.

LTV in cryptocurrency lending helps maintain an appropriate balance between the loan amount and collateral value, limiting risks for liquidity providers. Without this mechanism, cryptocurrency lending would be significantly riskier.

How is LTV calculated in cryptocurrency?

LTV in cryptocurrency lending is calculated using the following formula:

LTV = (Loan Amount / Current Market Value of Collateral) × 100%.

For example, a borrower takes out a cryptocurrency loan of 20 ETH, worth $50,000, using 1 BTC, worth $100,000, as collateral. In this case, the LTV is 50%.

LTV = ($50,000 / $100,000) × 100% = 50%.

If the price of ETH rises to $3,000, the LTV increases to 60%.

LTV = (20 × $3,000 / $100,000) × 100% = 60%.

If the Bitcoin price then falls to $80,000, the LTV reaches 75%, bringing the position closer to liquidation.

LTV = ($60,000 / $80,000) × 100% = 75%.

It is also important to account for interest, which affects LTV in crypto. If the annual interest rate is 5%, the outstanding debt will increase from 20 ETH to 21 ETH after one year, assuming simple interest:

20 ETH × (1 + 0.05) = 21 ETH.

If cryptocurrency prices remain unchanged (ETH at $3,000 and BTC at $80,000), the LTV will rise to 78.75%:

LTV = (21 × $3,000 / $80,000) × 100% = 78.75%.

Note: In DeFi, interest generally accrues continuously rather than once a month, as is common with traditional bank loans. Accordingly, LTV in cryptocurrency lending also increases gradually over time, exposing borrowers to greater risks.

How can you reduce liquidation risk when LTV is high?

There is no universal rule defining what an appropriate LTV in cryptocurrency should be. However, one thing is clear: the higher the ratio, the more likely a lending position is to be liquidated.

This risk is particularly significant because cryptocurrencies are highly volatile, and prices can change by tens of percent in just a few days or even hours. Under such conditions, borrowers may have very little time to prevent the forced closure of their lending positions as LTV rises rapidly.

Cryptoasset volatility is closely related to liquidity*. Therefore, it is generally safer to use highly liquid cryptocurrencies as both collateral and borrowed assets, since they tend to be considerably less volatile than low-market-cap altcoins.

* Liquidity is the ability to quickly buy or sell an asset at a price close to its market value without significantly affecting its price. The higher the liquidity, the easier it is to execute a large transaction without causing noticeable price movements. When liquidity is low, even a relatively small transaction can trigger substantial price fluctuations, while finding a buyer or seller may take longer.

For stablecoins, a higher LTV in lending may be acceptable due to their relatively low volatility. However, consider the risk of a stablecoin losing its peg to the underlying currency. If this happens, the borrower may also face liquidation.

If LTV in crypto rises too high (70% or more), reduce it to minimize liquidation risk. A rapid decline in the value of the collateral and/or a sharp increase in the price of the borrowed asset may cause the position to be liquidated before the borrower has time to close it.

There are several ways to reduce LTV in crypto when it rises:

Increase the amount of collateral;
Repay part of the loan;
Use a different, less volatile cryptoasset as collateral, provided the lending platform allows it.

If a lending position reaches the liquidation threshold, it may be forcibly liquidated by specialized market participants known as liquidators. They repay part or all of the borrower's outstanding debt in exchange for a corresponding portion of the collateral. Liquidators receive an additional reward for carrying out this process, known as a liquidation bonus.

The risk of liquidation associated with a high LTV in DeFi may increase further when market liquidity is insufficient. For example, if a borrower decides to sell cryptocurrency to repay a loan, a lack of buyers may make the transaction difficult or force them to sell the asset at an unfavorable price. As a result, the borrower may not have enough time to repay the debt or increase the collateral before liquidation occurs.

If collateral value drops sharply, a situation may arise in which even selling all the collateral does not generate enough funds to repay the loan in full. In DeFi, this uncovered debt is known as bad debt. It creates financial risks primarily for the lending protocol and its liquidity providers.