In DeFi, the functioning of lending pools is very different from conventional financial systems. Rather than banks setting interest rates or credit conditions, DeFi relies on automated mechanisms dictated by smart contracts. One of the most influential mechanisms involves the utilization ratio: a measure of how much of a lending pool's liquidity is currently being borrowed.
The utilization ratio plays a key role in assessing borrowing costs, leverage conditions, and general dynamics within DeFi margin trading. It helps protocols keep a balance between liquidity providers who supply the capital to earn yield and borrowers who need the liquidity to leverage their positions.
It's important that traders, liquidity providers, and developers understand the dynamics at play in utilization and how it affects borrowing costs for safely and effectively navigating DeFi.
What is the utilization ratio in DeFi?
The utilization ratio is the percentage of the assets in the lending pool that are being borrowed. For instance, if a pool has 100 ETH supplied and 60 ETH borrowed, then the utilization ratio is 60%.
Though simple in calculation, the utilization ratio has deep implications for the whole margin trading system and is a fundamental indicator in many crypto lending protocols.
Why Utilization Ratios Matter
They show liquidity health:
A low utilization ratio indicates a good availability of liquidity, while a high ratio reveals that the availability of liquidity is tightening.
They guide interest rate adjustments:
Most DeFi protocols dynamically adjust borrowing costs in accordance with how high or low the utilization gets.
They influence user behavior:
The behavior of borrowers, liquidity providers, arbitrage traders, and even bots depends on the level of utilization.
They help protocols remain stable:
Without utilization-based adjustments, pools could sit idle, with low yields, or get drained and see no liquidity whatsoever.
Therefore, the utilization ratio is a direct indicator of how liquidity flows in and out of the system.
How Utilization Ratios Affect Borrowing Costs
The reason that borrowing costs move with utilization is due to simple economic principles: when liquidity is plentiful, borrowing is cheap; when liquidity is scarce, borrowing becomes expensive.
Below is a detailed breakdown of how borrowing costs shift across the different utilization environments.
1. Low Utilization → Lower Borrowing Costs
When only a small portion of the pool is borrowed:
Liquidity is abundant
Traders can easily borrow assets without creating liquidity pressure.
Protocols keep interest low
Lending pools thus want to incentivize more borrowing activity and keep rates reasonably affordable.
Borrowers benefit
Lower rates make margin trading more profitable, especially for long-term strategies.
LP returns remain low
Because few borrowers are paying interest, liquidity provider returns remain stable but at low levels.
Market environment
This usually happens when the markets are less volatile, traders are more conservative, or the demand for leverage hasn't picked up yet.
Low utilisation supports a healthy pool with cheap leverage and plenty of liquidity.
2. Moderate Utilization → Balanced Borrowing Costs
This is the most stable and productive range for lending protocols.
Liquidity is being utilized effectively
Moderate borrowing means that the pool is neither unemployed nor stretched to its limits.
Interest rates remain predictable
Loan rates don't fluctuate as dramatically, something that can give traders confidence in longer-term strategies.
LPs earn attractive yields
More borrowers translate to more interest collected, hence increasing returns.
Fair pricing for borrowers
Rates are higher than in low-utilization environments but remain competitive.
Market behavior
This zone often characterizes healthy market activity, as it reflects balanced leverage across traders.
Most DeFi protocols design their models to remain in this region for as long as possible.
3. High Utilization → Rapidly Increasing Borrowing Costs
When the pool becomes heavily borrowed:
Liquidity scarcity appears
Only a small portion of the assets is unborrowed, therefore pressuring the pool.
Expensive borrowing
Interest rates rise sharply to deter further borrowing.
LP produces spike
More rewarding for liquidity providers correspondingly attracts more deposits.
There is an increase in borrower stress
Long-term leverage for traders means interest costs that grow rapidly.
Market sentiment
High utilization often occurs during bull runs, volatility spikes, or rapid market movements when traders seek aggressive leverage.
This phase is quite necessary to avoid liquidity exhaustion and ensure natural deleveraging.
Why Utilization Ratios Increase Borrowing Costs
The relationship of utilization to borrowing cost is not arbitrary but reflects fundamental economic and risk-management principles.
Key Reasons Explained in Depth
To protect liquidity providers
When most liquidity is borrowed, LPs take on more risk. Increasing the borrowing cost compensates them for that risk and incentivizes the entry of new LPs into the pool.
To prevent the pool from running dry
If utilization reaches 100%, it becomes impossible to withdraw. High borrowing rates force borrowers to repay earlier, which reduces pressure on the pool.
To limit excessive leverage
High utilization is usually due to traders wanting too much leverage. Increasing the cost of borrowing discourages over-leveraging during volatile periods.
Restoring the balance of liquidity
Naturally, steep interest rates cause traders to repay loans or reduce leverage, an action that gradually brings utilization back to its stable levels.
This mechanism keeps the lending pools functional even when markets experience extreme conditions.