Undercollateralization

The primary benefit is the dramatic increase in capital efficiency. Borrowers can access more liquidity than their posted collateral, enabling leveraged positions, working capital for businesses, or larger investments without locking up equivalent value. This is a fundamental shift from traditional overcollateralized DeFi loans.

To mitigate risk without full collateral, protocols implement alternative trust mechanisms. These can include:

• On-chain credit scoring based on historical transaction behavior.
• Social attestations or decentralized identity verification.
• Delegation from a credit-worthy entity (e.g., Aave's Credit Delegation).

Since loans are not fully backed, protocols employ aggressive liquidation mechanisms to protect lenders. This often involves:

• Automated margin calls when a borrower's health factor deteriorates.
• Partial or full liquidation of the undercollateralized position.
• Liquidation penalties that incentivize keepers to close risky positions swiftly.

Risk is often socialized or transferred within the protocol. Common structures include:

• Senior/Junior Tranches: Losses first absorb junior capital, protecting senior lenders.
• Insurance Pools: A dedicated pool of funds covers defaults, funded by protocol fees.
• Underwriting by Delegators: In credit delegation, the delegator's staked assets back the loan.

Real-world implementations showcase different approaches:

• Aave: Credit Delegation allows users to delegate borrowing power to specific addresses.
• Maple Finance: Institutional capital pools with off-chain underwriting and on-chain execution.
• Goldfinch: Uses "Backers" who provide first-loss capital and perform off-chain due diligence on borrowers.

The core trade-off is the introduction of counterparty risk and systemic risk. The system's stability depends on the accuracy of credit assessments and the robustness of liquidation systems. During market stress, correlated defaults or failed liquidations can lead to protocol insolvency, as seen in events like the Maple Finance institutional pool defaults.

Overcollateralization requires collateral worth more than the loan (e.g., 150% LTV), acting as a safety buffer for price volatility. Undercollateralization allows borrowing more than the posted collateral's value, relying on non-collateral mechanisms like credit scoring, identity, or future cash flows to secure the loan and manage lender risk.

A flash loan is an extreme form of undercollateralized lending where the loan requires zero collateral, provided the borrowed amount plus a fee is repaid within a single blockchain transaction. This is enforced by the protocol's smart contract, which atomically executes and reverts the entire transaction if repayment fails.

Undercollateralized protocols introduce unique risks managed by oracles and reputation systems.

• Oracle Risk: Dependence on accurate off-chain data (e.g., credit scores, real-world asset prices).
• Default Risk: Mitigated through diversification pools, senior tranche structures, and legal recourse.
• Liquidation Complexity: More challenging without excess collateral, often requiring longer timeframes or off-chain enforcement.

Liquidation is the enforced process of selling a borrower's collateral to repay their debt when their position becomes undercollateralized, typically triggered by falling below a minimum collateralization ratio. This mechanism protects lenders from loss but can lead to liquidation cascades if many positions are liquidated simultaneously, rapidly driving down asset prices.

Overcollateralization is the standard, risk-averse model where the value of posted collateral exceeds the loan value. This creates a safety buffer against price volatility. It is the foundational security model for major DeFi lending protocols (e.g., Aave, Compound) and is contrasted with the higher-risk model of undercollateralized lending.

Credit-based lending refers to traditional or on-chain systems where loans are issued based on a borrower's creditworthiness, not solely on collateral value. This inherently allows for undercollateralized or uncollateralized positions. On-chain examples include protocols using credit delegation, identity-based scoring, or reputational collateral.

The liquidation price is the specific market price of the collateral asset at which a loan position will become undercollateralized and subject to liquidation. It is a critical risk parameter for borrowers. For example, if ETH is collateral for a DAI loan, the liquidation price indicates how low ETH can fall before the position is at risk.