Collateral Swap

The primary motivation is to mitigate liquidation risk by swapping volatile collateral for a more stable asset. For example, if the value of ETH collateral is falling, a user can swap it for a stablecoin like DAI to protect their loan's health factor. This is a proactive alternative to being liquidated.

• Key Benefit: Maintains the loan's solvency during market downturns.
• Mechanism: Executed via a flash loan or direct swap within the protocol's interface.

Users swap collateral to access better loan-to-value (LTV) ratios and borrow more against their assets. Protocols assign different risk weights; swapping a low-LTV asset for a higher-LTV one (e.g., from WBTC to stETH on Aave) increases borrowing power.

• Goal: Maximize the utility of locked capital.
• Example: Swapping to a collateral type with a deeper liquidity pool can also reduce borrowing rates.

Enables users to reallocate collateral to pursue higher yields or new strategies without repaying debt. A user might swap staked ETH (stETH) for a yield-bearing vault token like cvxCRV to earn additional APY on their collateral while maintaining the same debt position.

• Strategy: Shift collateral into assets aligned with current market opportunities.
• Consideration: Must account for the new asset's volatility and protocol-specific rules.

Facilitates moving a loan position from one lending protocol to another or upgrading to a new collateral type within the same protocol. This is essential during protocol upgrades (e.g., Aave V2 to V3) or when better terms are available elsewhere.

• Process: Often involves a flash loan to repay the old debt, claim the original collateral, and re-deposit it into the new platform.
• Tooling: Specialized aggregators (like DeFi Saver) automate these complex multi-step transactions.

Sophisticated actors use collateral swaps for arbitrage when price discrepancies exist between collateral assets across protocols. By swiftly swapping collateral and adjusting debt, they can capture risk-free profits, a subset of Maximal Extractable Value (MEV).

• Mechanism: Bots monitor for LTV ratio differences or oracle price delays.
• Impact: This activity can help correct market inefficiencies but also adds to network congestion.

A successful swap depends on several smart contract and market conditions:

• Oracle Support: Both assets must have reliable, on-chain price feeds.
• Liquidity: Sufficient market liquidity for the swap pair at a minimal slippage.
• Protocol Permission: The lending protocol must whitelist both the incoming and outgoing collateral assets.
• Health Factor: The swap must not leave the loan undercollateralized; it often requires an over-collateralized position to initiate.

While not a direct swap function, Aave V3 enables efficient collateral management through two mechanisms:

• e-Mode (Efficiency Mode): Allows borrowing at optimal rates by isolating correlated assets (e.g., stablecoins).
• Flash Loans: Users can execute a custom swap in a single transaction: take a flash loan, repay old collateral, deposit new collateral, and repay the flash loan, effectively swapping collateral.

Compound III's architecture, with a single borrowable base asset (e.g., USDC) and multiple isolated collateral types, simplifies the collateral swap concept. A user can withdraw one collateral asset and supply another in separate transactions, with the protocol's risk management and oracle prices ensuring the account remains solvent.

Dedicated protocols built specifically for cross-margin and collateral optimization:

• MetaStreet: Focuses on efficiently recycling and pooling NFT collateral liquidity.
• Timeswap V2: Uses an AMM model for fixed-term loans, allowing collateral to be dynamically priced and swapped within its pools. These protocols abstract the complexity of direct vault management.

The technical sequence for a trustless collateral swap typically involves:

1. Price Oracle Check: Verifying prices for both collateral assets.
2. Debt & Health Check: Ensuring the new collateral maintains the required liquidation threshold.
3. Atomic Execution: In one transaction: withdraw Collateral A, swap it for Collateral B on a DEX (e.g., Uniswap), and deposit Collateral B.
4. State Update: The protocol updates the user's position with the new collateral type and amount.

Collateral swap protocols provide critical utility for sophisticated DeFi users:

• Risk Management: Rotate out of volatile collateral into more stable assets ahead of market downturns.
• Capital Efficiency: Move collateral to assets with better Loan-to-Value (LTV) ratios to borrow more.
• Yield Optimization: Switch collateral to an asset earning yield (e.g., a staked derivative) without closing a productive borrowing position.
• Tax Efficiency: Avoids the taxable 'disposition' event that would occur from closing and reopening a loan.

The collateralization ratio is the value of a user's collateral divided by the value of their borrowed assets, expressed as a percentage. It is a critical risk metric in lending protocols.

• A higher ratio indicates a safer, less risky position.
• If the ratio falls below the protocol's liquidation threshold, the position can be liquidated.
• Swapping to a more stable or higher-valued collateral asset can improve this ratio.

This is the ongoing process of monitoring and adjusting a borrowing position on a protocol like MakerDAO or Aave. A collateral swap is a key tool for this, allowing users to:

• Mitigate risk by swapping volatile collateral for stablecoins.
• Unlock borrowing power by swapping to an asset with a better loan-to-value (LTV) ratio.
• Optimize yield by rotating into collateral assets that can be simultaneously staked or farmed.

A flash loan is an uncollateralized loan that must be borrowed and repaid within a single blockchain transaction. It is a powerful primitive that can be used to execute complex DeFi strategies, including arbitrage and collateral swaps.

• Users can take a flash loan to provide the temporary liquidity needed to perform a swap in one atomic action.
• This enables sophisticated position management without requiring the user's own upfront capital for the interim steps.

Liquidation is the forced sale of a borrower's collateral by the protocol when their health factor/collateralization ratio becomes unsafe. It is the primary risk a collateral swap aims to avoid.

• Swapping to a less volatile asset reduces the risk of a sudden price drop triggering liquidation.
• Some protocols offer liquidation protection features that can automatically execute collateral swaps to maintain a safe position.

A cross-chain bridge is a protocol that enables the transfer of assets and data between different blockchain networks. It is a foundational technology for cross-chain collateral swaps.

• To swap collateral from Ethereum to Avalanche, a user must first bridge the asset.
• Bridges introduce considerations like bridge security, transfer time, and fees, which impact the swap's feasibility and cost.

An Automated Market Maker (AMM) is a decentralized exchange protocol that uses liquidity pools and a constant product formula to facilitate asset swaps. It is the most common execution layer for a collateral swap.

• Swaps are executed against pools on DEXs like Uniswap or Curve.
• The swap's success and price impact depend on the liquidity depth of the relevant trading pairs.