From financemagnates

Collateral, and in particular over-collateralization, is a fundamental mechanism that’s necessary to secure all lending and borrowing activities in decentralized finance.

Collateralization is essential for DeFi and the basic concept is simple enough. By depositing more capital than you intend to borrow, the process protects lenders from the risk of the borrower defaulting. The only benefit for borrowers was that collateral allows them to access loans in the first place, but newer protocols like Dolomite are emerging that can extend the benefits of over-collateralization to both sides.

What is over-collateralization?

In the DeFi ecosystem, protocols cannot utilize traditional credit scoring systems due to its decentralized nature, which essentially means users are anonymous. So to facilitate access to loans, users are required to deposit collateral, in the form of cryptocurrency tokens.

DeFi loans are therefore structured as over-collateralized arrangements, and involve the borrower depositing crypto assets that are greater in value than the amount they intend to borrow. It’s a necessary practice due to the high volatility of crypto, where asset prices can and do fluctuate by significant degrees in very short periods of time. The over-collateralization process creates a buffer that offers protection to liquidity providers and other lenders, in the event that the value of the collateral declines sharply.

Collateralization is essential for DeFi and the basic concept is simple enough. By depositing more capital than you intend to borrow, the process protects lenders from the risk of the borrower defaulting. The only benefit for borrowers was that collateral allows them to access loans in the first place, but newer protocols are emerging that can extend the benefits of over-collateralization to both sides.

In most DeFi protocols, these safeguards extend to liquidation. Should the collateral’s value fall below a minimum threshold, the loan will be liquidated, meaning the collateral is sold and users to repay the lenders, unless the borrower is willing to deposit more to ensure their total deposit meets the minimum requirements.

Of course, the over-collateralization model is far from ideal, as it obviously excludes those who perhaps need financing more than anyone else – those who don’t possess the collateral to begin with. Nevertheless, it’s crucial for most lenders, especially traditional institutions, who are required to operate in systems with robust risk mitigation frameworks. The collateral cushion provides peace of mind that loans are always fully-secured, even when the underlying asset is susceptible to rapid and unpredictable price changes.