Collateral Factor

A Collateral Factor (also known as Loan-to-Value or LTV ratio) is a risk parameter, expressed as a percentage, that determines the maximum amount a user can borrow against a specific asset deposited as collateral in a decentralized finance (DeFi) lending protocol. For example, if ETH has a collateral factor of 75%, a user depositing $100 worth of ETH can borrow up to $75 worth of other assets. This creates a safety buffer to protect the protocol from undercollateralization if the asset's value declines.

The parameter is set by protocol governance based on an asset's risk profile, considering its price volatility, liquidity, and oracle reliability. A stablecoin like USDC typically has a high collateral factor (e.g., 85%) due to its price stability, while a more volatile asset like a memecoin might have a factor of 40% or lower. This factor directly defines the liquidation threshold; if the borrowed value exceeds the collateral value multiplied by this factor, the position becomes eligible for liquidation to repay the debt.

From a systemic perspective, collateral factors are a primary tool for managing the protocol's overall risk exposure. They balance user leverage against the security of the lending pool. A higher factor increases capital efficiency for users but raises protocol risk, while a lower factor enhances safety at the cost of reduced borrowing power. Protocols like Aave and Compound publicly display and adjust these factors through community governance votes.

The collateral factor (also known as the loan-to-value or LTV ratio) is a risk parameter, expressed as a percentage, that determines the maximum amount a user can borrow against a specific asset deposited as collateral in a decentralized lending protocol. For example, if ETH has a collateral factor of 75%, a user depositing $100 worth of ETH can borrow up to $75 worth of other assets. This parameter is set by protocol governance based on an asset's volatility, liquidity, and market depth to protect the protocol from undercollateralization during market downturns.

Mechanically, the collateral factor creates a borrowing power or borrow capacity for each supported asset. A user's total borrowing limit is calculated by summing the value of each collateral asset multiplied by its respective factor. If the value of the borrowed assets (the debt) exceeds this limit, the position becomes eligible for liquidation. This system ensures that the total debt in the protocol is always over-collateralized, safeguarding the liquidity providers who supply the lending pools.

Protocols like Compound and Aave dynamically adjust these factors through governance votes. Stablecoins like USDC typically have higher factors (e.g., 80-85%) due to their price stability, while more volatile assets like crypto-native tokens have lower factors (e.g., 50-65%). The factor directly influences an asset's utility within DeFi money markets; a higher factor makes an asset more capital-efficient as collateral but increases systemic risk if not calibrated correctly.

From a risk management perspective, the collateral factor, combined with the liquidation threshold and liquidation penalty, forms a critical triad. While the factor sets the initial borrowing limit, the liquidation threshold is often set a few percentage points lower, creating a buffer zone before a position is actually liquidated. This design prevents instantaneous liquidations from minor price wobbles and gives borrowers a chance to add more collateral or repay debt.

In decentralized finance (DeFi) protocols like Aave and Compound, the collateral factor (also known as the loan-to-value or LTV ratio) is a percentage that defines the maximum amount a user can borrow against a specific collateral asset. For example, if ETH has a collateral factor of 75%, a user depositing $100 worth of ETH can borrow up to $75 worth of other assets. This parameter acts as a primary buffer against liquidation risk, ensuring the loan is always overcollateralized and protecting the protocol from undercollateralized positions if the asset's value declines.

Protocol governance, often through a decentralized autonomous organization (DAO), is responsible for setting and adjusting collateral factors based on rigorous risk assessment. Key considerations include the asset's price volatility, liquidity depth on decentralized exchanges, and its historical correlation with other assets in the protocol's market. A stablecoin like USDC will typically have a higher collateral factor (e.g., 85%) than a more volatile asset like a memecoin, which might have a factor of 40% or lower. These adjustments are a continuous process of risk parameter tuning to maintain protocol solvency.

The collateral factor directly interacts with other risk mechanisms, most notably the liquidation threshold and liquidation penalty. While the collateral factor sets the borrowing limit, the liquidation threshold is the asset value ratio at which a position becomes eligible for liquidation. A safety margin is maintained between these two values. If a user's health factor deteriorates because their collateral value falls or their debt rises, liquidators are incentivized to repay part of the debt in exchange for the collateral at a discount, restoring the protocol's health. Thus, the collateral factor is the foundational lever for managing the entire credit risk framework.