Collateralization Ratio

In decentralized lending, borrowers must provide collateral to secure a loan, as DeFi protocols do not rely on traditional credit scores. The collateralization ratio ensures lenders are protected from default by requiring borrowers to deposit assets worth more than the loan amount.

💊 How It Works

• Overcollateralization – Most DeFi loans require borrowers to deposit more collateral than they borrow (e.g., 150% collateralization ratio means $1,500 in collateral is needed to borrow $1,000).
• Loan-to-Value (LTV) Ratio – Inverse of collateralization ratio, representing the percentage of a loan relative to the collateral value.
• Liquidation Threshold – If the collateralization ratio falls below a set threshold due to price fluctuations, the loan may be liquidated to protect lenders.
• Dynamic Adjustments – Some protocols adjust collateral requirements based on asset volatility and market conditions.

🏛 Example 1: Aave Lending Collateralization

A user deposits 2 ETH as collateral on Aave and borrows 1,000 USDC. If ETH is valued at $2,000 per token, the collateralization ratio is 400% ($4,000 collateral for a $1,000 loan). If ETH’s price drops significantly, the ratio falls, potentially triggering liquidation.

🏛 Example 2: MakerDAO’s DAI Stablecoin Loans

MakerDAO requires a minimum 150% collateralization ratio for DAI loans. If a user locks up $3,000 worth of ETH, they can borrow up to 2,000 DAI. If ETH’s price drops below a critical threshold, their collateral may be auctioned to maintain protocol stability.

📚 References

1. Investopedia – Collateralization: Definition, How It Works, Examples

2. IQ.wiki – Collateralization Ratio

⚠️ Controversies & Misconceptions

• "Collateralization ratio guarantees loan safety" – While it helps secure loans, extreme price volatility can still lead to liquidations.
• "All DeFi loans require the same ratio" – Different protocols have varying collateralization requirements based on asset type and risk assessment.

🚀 Conclusion

The collateralization ratio is a fundamental concept in DeFi lending, ensuring that loans remain secure and overcollateralized to mitigate risk. However, borrowers must monitor their collateral value to avoid liquidation during market downturns.

Related Terms

• Borrowing & Lending

  Borrowing and lending in DeFi refers to the process of lending digital assets to earn interest (lending) or borrowing assets by providing collateral (borrowing). Unlike traditional finance, DeFi lending platforms operate without intermediaries, relying on smart contracts to facilitate loans and manage collateral.

• ERC-20

  ERC-20 is a widely used token standard on the Ethereum blockchain for fungible tokens. It defines a set of rules that enable seamless interaction between tokens and Ethereum-based applications.

• Assets Under Management (AUM)

  Assets Under Management (AUM) refers to the total market value of assets that a financial institution, investment firm, or DeFi protocol manages on behalf of clients or investors. In the DeFi space, AUM represents the total value of user funds locked or managed within a platform, such as lending protocols, yield farms, or investment DAOs.