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

• Aave Docs – Understanding Collateralization & LTV Ratios
• MakerDAO Whitepaper – How Collateralized Debt Positions (CDPs) Work

⚠️ 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.