What is Collateralization in DeFi?

by | Nov 1, 2020 | Industry | 0 comments

In DeFi, lending and borrowing is the primary activity. According to DeFi Pulse, the lending market accounts for over 80% of the total value locked in DeFi currently. Most lending apps require borrowers to lock up a particular digital asset for newbies when applying for a loan. The locked amount is known as collateral.  

Collateralized Loans 

Collateralization is when a borrower deposits some money as a way for the lender to recover their investment in case the borrower defaults on the terms and conditions of the loan, or when the borrower has unceasingly failed to pay back the loan within a given time. 

Lenders mostly require borrowers to pledge a valuable asset as collateral in which they have the right to possess it when the loan defaults. In the traditional banking system, the most common types of collateral used to get a loan include property, land, automobiles, art, jewelry, and securities. 

Collateralized Loans in DeFi

In DeFi, collateralized loans are the backbone of open lending applications. Considering that DeFi facilitates open, pseudo-anonymous finance, users lack credit scores or formal identity to secure loans. Thus, like mortgages, most DeFi lending protocols require borrowers to collateralize their loans as an enticement to hold them accountable for repaying the money.   

Nevertheless, the significant difference between traditional collateralization and DeFi collateralization (as it stands) is that collateralizing a loan on DeFi protocols, like Compound and MakerDAO, requires the borrower to over-collateralize the loan. This implies that the collateral’s value must exceed the amount of the loan to secure it. For example, MakerDAO requires users to collateralize their loans, at a minimum, of 150% of the loan value.  

To clarify the above example, if you plan to secure a loan of 100 Dai on MakerDAO, you must collateralize your loan with a minimum of $150 in Ether. You can select your collateralization ratio, which calculates the liquidation price and amount of Dai you will get. The liquidation price is the price of Ether, where the value of your loan will be more than the value of the minimum collateralization ratio. 

Considering that the minimum collateralization ratio is 150% and you collateralized your loan with $150 ETH for 100 DAI, a decline in ETH price below $150 would subject your loan to the 13% liquidation penalty. Because of this, most borrowers collateralize their loans well above 200%, with the average collateralization ratio all protocols being 348%. This is done to give lenders a friendly wadding in case of volatility in the cryptocurrency markets, and avoid the liquidation penalty. 

Borrower Protection for DeFi Collateralized Loans 

In DeFi, there are few borrower protection rules of lending. Unlike in the traditional banking system where both borrowers and lenders enjoy protections, like loan insurance, DeFi does not have any protection currently. Basically, the primary protection method of DeFi lending is the game theory and incentives behind over-collateralized loans. 

We are likely to see better protection rules for both borrowers and lenders as the DeFi space matures.     

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