Collateral Vault

The collateralization ratio (CR) is the primary risk metric, calculated as (Value of Collateral / Value of Debt) * 100%. It determines the safety buffer against liquidation.

• Minimum CR: The threshold at which a vault becomes eligible for liquidation.
• Target CR: A user-set ratio above the minimum to avoid market volatility.
• Example: A $150 ETH vault backing $100 DAI debt has a 150% CR.

An automated process triggered when a vault's collateralization ratio falls below the minimum requirement. A liquidation penalty is applied, and the vault's collateral is auctioned or sold to a keeper bot to repay the debt, protecting the protocol from insolvency. Key components include:

• Liquidation Price: The asset price at which the CR hits the minimum.
• Liquidation Fee: A penalty paid by the vault owner, often distributed to the liquidator and the protocol.

A protocol-level parameter that limits the total amount of debt (e.g., DAI) that can be generated against a specific collateral asset type. It is a critical risk management tool to prevent overexposure to any single asset and maintain system stability. For instance, a vault type for WBTC may have a global debt ceiling of $1 billion.

The recurring cost of maintaining debt in a vault, typically expressed as an annual percentage rate (APR). This fee accrues continuously and is paid in the borrowed asset, increasing the vault's debt balance over time. It is a key lever for monetary policy within decentralized finance (DeFi) protocols, helping to regulate the supply of minted stablecoins.

Vaults accept specific, whitelisted assets as collateral, each with its own risk parameters set by governance. These include:

• Liquidation Ratio: The minimum CR for that asset.
• Debt Ceiling: As above.
• Stability Fee: As above.
• Collateral Factor / LTV (Loan-to-Value): The maximum debt allowed per unit of collateral (inverse of CR). Safer assets like ETH may have a 75% LTV, while volatile assets may have 40%.

Permissionless bots or agents that monitor vault health and perform critical maintenance functions to keep the system solvent. Their primary roles are:

• Liquidation: Identifying and executing liquidations on undercollateralized vaults for a profit.
• Auction Participation: Bidding on collateral in liquidation auctions.
• System Incentives: They are economically incentivized by liquidation penalties and auction discounts.

A collateral vault is a non-custodial smart contract that locks user-deposited assets. It enforces a collateralization ratio (e.g., 150%) by continuously comparing the value of the locked assets to the debt or synthetic value minted against it. If the ratio falls below a liquidation threshold, the vault can be partially or fully liquidated to repay the debt.

• Overcollateralized Lending (MakerDAO, Aave): Deposit ETH to mint a stablecoin (DAI) or borrow other assets.
• Leveraged Yield Farming: Use borrowed funds to increase farming position size (common on platforms like Alpha Homora).
• Synthetic Asset Minting (Synthetix): Lock SNX to mint synthetic dollars (sUSD) or synthetic commodities (sBTC).
• Cross-Chain Bridging (THORChain): Vaults secure assets on one chain while issuing a representation on another.

Vault solvency is managed by protocol-defined parameters:

• Collateral Factor / Loan-to-Value (LTV): Maximum debt allowed per unit of collateral (e.g., 75% LTV for ETH).
• Liquidation Threshold: The collateral ratio at which liquidation is triggered (e.g., 85%).
• Liquidation Penalty: Fee charged during liquidation, paid to the liquidator.
• Debt Ceiling: Maximum total debt that can be issued against a specific collateral type.

When a vault becomes undercollateralized, a liquidation is triggered. A liquidator repays part or all of the vault's debt in exchange for the underlying collateral at a discounted price (the liquidation penalty). This process is often performed via liquidation auctions (MakerDAO) or fixed-rate liquidation bonuses (Compound, Aave) to ensure the protocol remains solvent.

• Single-Asset Vaults: Hold one collateral type (e.g., just ETH).
• LP Token Vaults: Accept liquidity provider tokens (e.g., UNI-V2) as collateral, introducing impermanent loss risk.
• Yield-Bearing Vaults: Automatically stake or lend the collateral to generate yield (e.g., Yearn vaults, Aave's aTokens).
• Cross-Margin Vaults: Aggregate multiple positions into one vault to optimize capital efficiency (dYdX, GMX).

The core vulnerability is the vault's smart contract code. Bugs or exploits can lead to the direct loss of locked collateral. Key attack vectors include:

• Reentrancy attacks on withdrawal functions.
• Logic errors in liquidation or fee calculations.
• Upgradeability risks if the contract uses proxy patterns, where a malicious upgrade could drain funds. Regular audits and formal verification are essential mitigations.

Vaults rely on price oracles to determine the value of collateral and trigger liquidations. If an oracle provides incorrect data, the system becomes vulnerable:

• Price feed lag or failure can prevent timely liquidations.
• Oracle manipulation attacks (e.g., flash loan-enabled market swings) can artificially lower collateral value, causing unjust liquidations, or inflate it to allow excessive borrowing. Using decentralized, time-weighted average price (TWAP) oracles is a common defense.

The liquidation mechanism itself presents risks. To remain solvent, vaults liquidate undercollateralized positions, but this process can be predatory:

• Liquidation cascades can occur if a market downturn triggers many liquidations at once, depressing collateral prices further.
• Maximal Extractable Value (MEV) bots compete to liquidate positions, often resulting in high liquidation penalties for users and network congestion.
• Poorly calibrated liquidation thresholds and health factors can make positions unstable.

The inherent risk of the locked asset directly impacts vault security. This includes:

• Volatility risk: Highly volatile collateral requires higher overcollateralization.
• Censorship or depegging: For stablecoins used as collateral (e.g., in CDP models), a depeg event can collapse the system.
• Protocol risk: If the collateral is a yield-bearing token (e.g., a staked asset), failures in the underlying protocol can diminish the collateral's value or make it non-transferable.

Many vault protocols are governed by decentralized autonomous organizations (DAOs) or core teams, introducing governance risk:

• Malicious governance proposals could change critical parameters (like fees, collateral types, or oracle addresses) to drain funds.
• Vote manipulation through token accumulation.
• Admin key risk: Some systems retain privileged functions (e.g., emergency pauses, asset recovery) controlled by a multi-sig, creating a central point of failure.

Vaults create interconnected systemic risk within DeFi:

• Overcollateralization reliance: A sharp market drop can simultaneously endanger many positions across protocols.
• Composability risk: Vaults are often used as collateral elsewhere (re-collateralization). A failure in one protocol can propagate losses.
• Stablecoin instability: For algorithmic stablecoin vaults, a loss of peg can trigger a death spiral of minting and selling collateral.

The forced sale of a borrower's collateral when their loan's health factor falls below a protocol-defined threshold (e.g., 1.0). This automated process protects lenders from undercollateralized debt.

• Triggered by: Price volatility or debt accumulation.
• Liquidation Penalty: A fee (e.g., 5-15%) applied to the seized collateral, paid to the liquidator.
• Example: If ETH collateral value drops, a vault may be liquidated to repay the stablecoin debt.

A numerical metric representing the safety of a collateralized debt position. It is calculated as (Collateral Value * Collateral Factor) / Borrowed Value.

• HF > 1: Position is considered safe.
• HF ≤ 1: Position is at risk of liquidation.
• Collateral Factor: The maximum loan-to-value (LTV) ratio set by the protocol for a specific asset (e.g., 80% for ETH).

The foundational security model of most DeFi lending, where the value of deposited collateral must exceed the value of the borrowed assets. This creates a buffer against price fluctuations.

• Typical Minimum: Protocols require 110-150% collateralization.
• Purpose: Mitigates counterparty risk without requiring credit checks.
• Contrast: Undercollateralized lending relies on other mechanisms like credit scoring.

A cryptocurrency designed to maintain a stable value, typically pegged to a fiat currency like the US Dollar. They are the primary debt asset minted from collateral vaults.

• Examples: DAI, USDC, USDT.
• Role in Vaults: Users deposit volatile collateral (e.g., ETH) to mint stablecoins, accessing liquidity without selling their assets.
• Mechanisms: Can be collateral-backed (like DAI from Maker) or algorithmic.

The practice of deploying assets from a vault to generate additional yield. This often involves using borrowed stablecoins in liquidity pools or other DeFi protocols.

• Common Strategy: Borrow DAI against ETH collateral, supply DAI to a lending protocol for interest.
• Risk: Increases smart contract risk and exposure to impermanent loss if providing liquidity.
• Automation: Often managed by vault strategies in Yearn Finance or similar yield aggregators.

A protocol-level parameter that limits the total amount of debt (e.g., a specific stablecoin) that can be minted against a particular type of collateral. This is a critical risk management tool.

• Purpose: Prevents overexposure to a single collateral asset and systemic risk.
• Governance: Often set and adjusted by decentralized governance (token holders).
• Example: MakerDAO may set a debt ceiling of 500 million DAI for wBTC collateral.