Overcollateralization

The primary risk for borrowers is forced liquidation. If the value of the collateral asset falls relative to the borrowed asset, the collateralization ratio can drop below the protocol's liquidation threshold. This triggers an automated sale of the collateral, often at a penalty, to repay the debt. Borrowers can lose a significant portion of their collateral, especially during periods of high volatility or slippage.

Overcollateralization locks up more capital than is borrowed, creating a significant opportunity cost. For example, to borrow $10,000 of DAI, a user might need to lock $15,000 in ETH. This capital cannot be deployed elsewhere, making the system inefficient compared to undercollateralized or uncollateralized lending models in traditional finance.

The security of overcollateralized positions depends entirely on accurate oracle price feeds. If an oracle provides stale or manipulated data, it can cause:

• False liquidations of healthy positions.
• Undercollateralized positions to go undetected, threatening protocol solvency. This makes protocols vulnerable to oracle attacks and flash loan exploits designed to manipulate asset prices on a single exchange.

During sharp market downturns, mass liquidations can create a death spiral effect:

1. Falling collateral prices trigger liquidations.
2. Liquidators sell collateral, driving prices down further.
3. This triggers more liquidations, creating a feedback loop. This can lead to insolvency if the liquidation system is overwhelmed, potentially causing losses for lenders and destabilizing connected protocols.

The risk profile depends heavily on the chosen collateral. Using a highly volatile asset (e.g., a low-cap altcoin) requires a much higher collateral factor than a stable asset. Furthermore, if a protocol's total value locked (TVL) is concentrated in one or two volatile assets, a crash in those assets poses an existential risk to the entire system, as seen with MIM and its reliance on UST.

The automated liquidation engine must function flawlessly under stress. Risks include:

• Network congestion delaying liquidations, allowing positions to become undercollateralized.
• Insufficient liquidity in the market for liquidators to sell collateral profitably.
• Front-running by MEV bots, which can extract value from the liquidation process, increasing costs for the borrower.

The collateralization ratio is the primary metric for measuring the safety of a loan. It's calculated as (Value of Collateral / Value of Debt) * 100%. A higher ratio indicates a larger safety buffer.

• Maintenance Ratio: The minimum threshold before a position is liquidated (e.g., 150% for MakerDAO's ETH-A vault).
• Liquidation Price: The asset price at which the collateral value falls to the maintenance ratio, triggering an automated sale.

Liquidation is the automated process of selling a borrower's collateral to repay their debt when their collateralization ratio falls below the protocol's liquidation threshold. This protects lenders from insolvency.

• Liquidation Penalty: A fee (e.g., 13% on MakerDAO) charged to the borrower, paid to the liquidator.
• Liquidation Engine: The smart contract logic that auctions collateral, often involving keepers or liquidators who bid on it.

Collateral-backed stablecoins are digital assets pegged to a fiat currency, like the US Dollar, and are directly enabled by overcollateralization.

• DAI: The canonical example, minted by depositing excess collateral (e.g., ETH) into MakerDAO vaults.
• LUSD: Issued by the Liquity protocol, backed solely by ETH with a minimum 110% collateral ratio.
• These contrast with algorithmic or fiat-backed (custodial) stablecoins.

A debt ceiling is a protocol-level parameter that limits the total amount of debt (e.g., DAI) that can be generated against a specific type of collateral. It's a critical risk control.

• Purpose: Prevents overexposure to a single collateral asset and manages systemic risk.
• Governance: Set and adjusted by decentralized autonomous organization (DAO) votes based on asset risk assessments.

Liquid Staking Derivatives like Lido's stETH or Rocket Pool's rETH have become major collateral assets. They represent staked ETH that earns rewards while remaining liquid.

• Utility: Allows users to earn staking yield and use the derivative as collateral to borrow other assets, a practice known as recursive lending or leveraged staking.
• Risk: Introduces correlation risk between the staking derivative's value and the borrowed asset.