Collateral Definition
In the context of blockchain and cryptocurrency, collateral is a security or asset that a borrower pledges or locks up to secure a loan or to perform an action within a blockchain-based protocol. It’s a form of risk management used by crypto lenders or DeFi protocols to ensure the borrower will pay back the loan or otherwise fulfill their obligations.
Collateral Key Points
- Collateral is an asset provided as security for repayment of a loan or to guarantee an action in a blockchain protocol.
- Collateral decreases the risk for the lender or protocol participant, and motivates the borrower to fulfil their obligations.
- In decentralized finance (DeFi), collateral is often locked in smart contracts until a loan is repaid.
- Many DeFi protocols require over-collateralization due to the price volatility of most cryptocurrencies.
What is Collateral?
Collateral is typically a high-value asset, which in the context of traditional finance, can include things like real estate, vehicles, or investments. In the world of crypto and blockchain, collateral is often provided in the form of cryptocurrency or tokens.
Why Use Collateral?
The main use of collateral is to decrease the risk to lenders while providing assurance that borrowers will repay their loans or meet their commitments. By offering collateral, the borrower provides reassurance that the lender can recoup their funds even if the borrower defaults.
How Does Collateral Work in DeFi?
In DeFi protocols, collateral works differently than in traditional finance. It’s often locked in a smart contract until the loan is repaid or some other condition is fulfilled. This greatly reduces the risk for lenders, as they know that the borrower has locked up assets of significant value.
Where is Collateral Used in DeFi?
Collateral is used extensively in lending protocols, decentralized exchanges, derivatives platforms, and prediction markets. The ability for these protocols to effectively freeze or lock-up collateral is one of the core innovations of decentralized finance.
When is Collateral Required?
Collateral is usually required when a borrower is considered high-risk or when the borrower and lender do not have an established relationship. In DeFi, collateral is generally required for all borrowers, regardless of their creditworthiness, because of the absence of a centralized authority to assess risk.
The Significance of Over-Collateralization
In DeFi, it’s common to require borrowers to over-collateralize their loans, meaning the value of the collateral far exceeds the value of the loan. Given the volatility in the cryptocurrency market, over-collateralized loans safeguard the interests of lenders and protocols, ensuring they don’t lose value when the market fluctuates.
