Collateral Factor

Protocols adjust Collateral Factors dynamically based on market volatility, liquidity depth, and oracle reliability. Common triggers for updates:

• High volatility events leading to increased liquidations.
• New asset listings require conservative initial factors.
• Governance proposals to optimize capital efficiency or de-risk the protocol.
• This ongoing calibration is a core decentralized risk management function.

The Collateral Factor is closely tied to, but distinct from, the Liquidation Threshold. In many protocols:

• Collateral Factor determines the borrowing power.
• Liquidation Threshold (usually higher) determines when a position becomes undercollateralized.
• For example, an asset may have a Collateral Factor of 75% but a Liquidation Threshold of 80%. This creates a buffer zone where borrowing is disabled but liquidation hasn't yet been triggered.

Yield farmers and borrowers compare Collateral Factors across protocols to optimize capital efficiency. Strategies include:

• Collateral Re-hypothecation: Using borrowed assets as collateral elsewhere, creating leveraged loops.
• Rate Arbitrage: Borrowing where the Collateral Factor is high to supply where yield is higher.
• Understanding these differences is crucial for managing portfolio risk and avoiding unexpected liquidations when market conditions shift.

The collateral factor (also called loan-to-value ratio or LTV) is a percentage (e.g., 75%) set by a protocol's governance that determines the maximum amount a user can borrow against their deposited collateral. It is calculated as Maximum Borrow = Collateral Value × Collateral Factor. A higher factor increases capital efficiency but also increases systemic risk.

Closely related to the collateral factor is the liquidation threshold, which is typically set a few percentage points higher (e.g., 80% vs. a 75% collateral factor). The difference between these values creates a safety margin or liquidation buffer. This buffer prevents immediate liquidation when a borrow position is opened and gives users time to add collateral or repay debt if their collateral value declines.

The primary purpose of the collateral factor is to enforce over-collateralization. If the factor is set too high for a volatile asset, a small price drop can cause many positions to become undercollateralized simultaneously, triggering a liquidation cascade. This can overwhelm liquidators, lead to bad debt, and threaten protocol solvency, as seen in events involving volatile assets like LUNA.

Collateral factors depend entirely on accurate, real-time price feeds from oracles. If an oracle provides a stale or manipulated price, the effective collateral factor becomes inaccurate. An inflated price makes undercollateralized positions appear healthy, allowing users to borrow more than the true collateral value supports, which creates unbacked debt (bad debt) for the protocol.

Setting collateral factors is a governance decision that balances risk and utility. Key risks include:

• Governance attacks: A malicious actor could propose and pass a vote to dramatically increase factors for a specific asset, enabling a massive, undercollateralized borrow-and-exit attack.
• Incompetent parameterization: Setting factors too high increases insolvency risk; setting them too low reduces protocol utility and competitiveness.

Not all collateral is equal. Protocols assign factors based on an asset's risk profile:

• High Liquidity / Low Volatility (e.g., ETH, stablecoins): Higher factors (e.g., 75-85%).
• Low Liquidity / High Volatility (e.g., long-tail altcoins): Much lower factors (e.g., 40-60%) or not accepted.
• Correlated Assets: Using two correlated assets (e.g., two ETH derivatives) as collateral increases risk, as they may crash together, negating diversification benefits.

The Loan-to-Value (LTV) Ratio is the maximum percentage of an asset's value that can be borrowed against it. It is the inverse of the collateral factor. For example, a 75% LTV means you can borrow up to $75 against $100 of collateral. This is the primary risk control mechanism, determining borrowing power and liquidation thresholds.

• Direct Inverse: LTV = 1 / Collateral Factor.
• Risk Gauge: A lower LTV indicates a more conservative, safer asset for the protocol.

Liquidation is the forced sale of a borrower's collateral when their debt position becomes undercollateralized, triggered by falling below the required health factor. This process protects lenders from bad debt.

• Trigger: Occurs when Health Factor < 1.0.
• Process: A liquidator repays part of the debt in exchange for the collateral at a discount (liquidation bonus).
• Purpose: Maintains solvency of the lending pool.

The Health Factor is a real-time metric representing the safety of a borrowing position. It measures how close a position is to liquidation.

• Calculation: Health Factor = (Total Collateral Value * Collateral Factor) / Total Borrowed Value.
• Interpretation: A value above 1.0 is safe. A value at or below 1.0 triggers liquidation.
• Dynamic: Fluctuates with asset prices and borrowed amounts.

Maximum Borrowing Capacity is the total amount a user can borrow against their deposited collateral, calculated using the collateral factors of each asset.

• Formula: Capacity = Σ (Collateral Amount * Price * Collateral Factor).
• Portfolio-Based: Considers the weighted risk of a mixed collateral portfolio.
• Critical Limit: Borrowing beyond this capacity is impossible; it defines the upper bound for a safe position.

Collateral factors are key risk parameters set and managed through protocol governance. Token holders vote to adjust these factors based on asset volatility, liquidity, and market conditions.

• Governance Control: Changes are proposed and executed via governance votes.
• Risk Framework: Part of a suite of parameters including reserve factors and liquidation bonuses.
• Dynamic Management: Allows protocols to adapt to new assets and market regimes.

This distinction defines how collateral factors are applied across a user's portfolio.

• Cross-Collateralization (e.g., Aave, Compound): All deposited assets are pooled to calculate a single borrowing capacity. The health factor is global.
• Isolated Collateralization (e.g., Euler, newer protocols): Assets are placed in isolated 'vaults' or 'tranches' with their own risk profiles. A failure in one pool does not affect others, allowing for higher risk/reward assets with tailored collateral factors.