Overcollateralization (OC)

The Collateralization Ratio is the primary risk metric, calculated as (Value of Collateral / Value of Loan) * 100%. A 150% CR means $150 of collateral secures a $100 loan. Protocols set Minimum Collateralization Ratios (e.g., 110% for MakerDAO's ETH-A vault) as a liquidation threshold. Users maintain a Safety Buffer by operating above this minimum.

If the collateral value falls and the CR hits the minimum threshold, a liquidation is triggered to protect lenders. This is an automated process where:

• A portion of the borrower's collateral is auctioned or sold.
• The proceeds repay the loan plus a liquidation penalty.
• Any remaining collateral is returned to the borrower. This mechanism ensures the loan remains fully backed, transferring risk from lenders to borrowers.

Not all assets are equal. Protocols categorize collateral by volatility and liquidity.

• Blue-chip collateral: Less volatile, highly liquid assets like ETH or wBTC, allowing lower minimum CRs.
• Exotic or volatile collateral: Assets like LP tokens or smaller altcoins require higher CRs (e.g., 175%+).
• Oracle Dependency: Prices are fed by oracles (e.g., Chainlink). Oracle failure or manipulation is a key systemic risk.

To manage exposure, protocols implement Debt Ceilings – a maximum amount of debt that can be issued against a specific collateral type. This:

• Limits systemic risk by capping exposure to any single asset.
• Isolates risk; a problem with one collateral type (e.g., a price crash) is contained within its ceiling.
• Requires governance to adjust, balancing capital efficiency with safety.

The Stability Fee is the variable interest rate charged on the borrowed stablecoin (e.g., DAI). It is a governance tool used to:

• Control supply: Raise rates to incentivize debt repayment and reduce DAI supply.
• Generate protocol revenue: Fees accrue to the protocol's treasury.
• Manage peg: Helps maintain the stablecoin's $1 peg by influencing demand for borrowing.

Overcollateralization contrasts sharply with under-collateralized or uncollateralized lending (e.g., in TradFi or some DeFi protocols like Aave's "credit delegation").

The critical enforcement layer for OC systems. Key components include:

• Liquidation Threshold: The collateral ratio at which a position becomes eligible for liquidation.
• Liquidation Penalty: A fee charged to the borrower during liquidation.
• Liquidation Mechanisms: Vary by protocol (e.g., Dutch auctions in MakerDAO, Stability Pool in Liquity, fixed discount sales in Aave).
• Oracle Dependence: All systems rely on price oracles to determine collateral value in real-time.

The primary purpose of overcollateralization is to create a liquidation buffer that protects lenders or protocols from price volatility. A common Loan-to-Value (LTV) ratio of 150% means a user must deposit $150 worth of collateral to borrow $100. This buffer absorbs market swings, preventing the loan from becoming underwater (debt > collateral value) during normal volatility. The required ratio varies by asset volatility; stablecoins may require 110%, while more volatile assets like ETH might require 170% or more.

When the value of the collateral falls too close to the debt value, a liquidation is triggered to repay the loan. This process is automated by smart contracts.

• Liquidation Threshold: The specific LTV ratio (e.g., 85%) at which a position becomes eligible for liquidation.
• Liquidation Process: Liquidators repay part or all of the debt in exchange for the collateral at a discount, ensuring the protocol remains solvent.
• Liquidation Penalty: A fee (e.g., 5-15%) charged to the borrower, which incentivizes liquidators and compensates the system.

The major drawback of overcollateralization is capital inefficiency. Users lock up significant capital that cannot be deployed elsewhere. For example, to mint $10,000 of a synthetic asset like DAI, a user might need to lock $15,000 in ETH. This high capital requirement limits accessibility and utility compared to undercollateralized or uncollateralized systems in traditional finance. It represents a key design trade-off between security and efficient capital utilization.

Overcollateralized systems are not immune to failure. Key risks include:

• Oracle Failure: If the price feed providing the collateral value is manipulated or fails, it can cause false liquidations or prevent necessary ones.
• Black Swan Events: Extreme, correlated market crashes can collapse collateral values across many positions simultaneously, overwhelming liquidation mechanisms and potentially causing insolvency.
• Liquidity Crunch: In a market downturn, a lack of liquidators or on-chain liquidity can cause bad debt to accumulate if positions cannot be liquidated in time.

The security of an overcollateralized system depends heavily on the quality of the collateral assets. Protocols manage this through:

• Whitelists: Only pre-approved, less volatile assets (e.g., ETH, WBTC, major stablecoins) are accepted.
• Risk Parameters: Each asset has unique LTV, liquidation threshold, and penalty settings based on its volatility and liquidity.
• Collateral Diversification: Using a basket of uncorrelated assets can reduce systemic risk compared to a single volatile asset.

The Collateral Factor or Loan-to-Value (LTV) Ratio is the maximum percentage of an asset's value that can be borrowed against. It is the inverse of the overcollateralization requirement. For example, an LTV of 75% on $100 of ETH means a maximum loan of $75, requiring at least 133% collateralization. This ratio is protocol-defined and varies by asset based on its volatility and liquidity.

Liquidation is the enforced sale of a borrower's collateral when their position becomes undercollateralized, typically triggered by market movements. This process protects lenders from losses. Key components include:

• Liquidation Threshold: The LTV ratio at which a position becomes eligible for liquidation.
• Liquidation Penalty: A fee paid by the borrower, added to the debt.
• Liquidators: Third parties who repay part of the debt in exchange for discounted collateral, ensuring protocol solvency.

Algorithmic stablecoins like DAI and LUSD are prime examples of overcollateralization in practice. They are not backed by off-chain assets but are minted when users deposit excess crypto collateral (e.g., ETH) into Vaults or Troves. The system's stability relies on the value of the locked collateral always exceeding the value of the stablecoins in circulation, with automated liquidation mechanisms to maintain this peg during market downturns.

The Health Factor is a real-time metric representing the safety of a borrowed position. It is calculated as (Total Collateral Value * Liquidation Threshold) / Total Borrowed Value. A health factor above 1.0 indicates an overcollateralized position; if it falls to 1.0, liquidation is triggered. It is a dynamic number that changes with market prices, allowing users to monitor their risk of liquidation and add more collateral or repay debt to maintain safety.

Undercollateralized Lending is a contrasting model where loans are issued with little or no upfront collateral, relying instead on other trust and risk assessment mechanisms. This includes:

• Credit Delegation: Using a third party's collateral (e.g., via Aave).
• Identity/Reputation-Based: Using off-chain credit scores or on-chain transaction history.
• Liquidity Pool Insolvency: Protocols like Maple Finance that assess institutional borrowers. These models introduce counterparty risk but enable greater capital efficiency.

Not all collateral is equal. Protocols categorize assets by risk profile, affecting their LTV ratios and liquidation penalties.

• Blue-Chip Crypto: (e.g., ETH, wBTC) - High LTV, lower penalty.
• Liquid Staking Tokens: (e.g., stETH) - Slightly lower LTV due to derivative risk.
• Stablecoins: (e.g., USDC) - High LTV, but carries depeg risk.
• LP Tokens & Altcoins: Much lower LTV due to volatility and impermanent loss risk. This tiering manages systemic risk within the lending protocol.