Collateralization Ratio

The collateralization ratio (CR) is a risk metric that expresses the value of a user's deposited collateral relative to their borrowed debt. It is calculated as:

CR = (Value of Collateral / Value of Debt) × 100%

• A ratio of 200% means the collateral is worth twice the borrowed amount.
• This ratio is dynamic, fluctuating with the market prices of both the collateral and borrowed assets.

The CR acts as a solvency buffer for lending protocols. Its primary functions are:

• Protecting Lenders: Ensures sufficient asset backing for loans, minimizing protocol losses.
• Triggering Liquidations: A falling CR below a liquidation threshold (e.g., 150%) flags the position as undercollateralized, enabling automated liquidation to repay the debt.
• Setting Borrowing Limits: The minimum collateralization ratio (e.g., 110% for MakerDAO's ETH-A vault) determines the maximum debt a user can take for a given collateral amount.

Protocols define specific liquidation thresholds and minimum ratios to manage risk.

• MakerDAO: Different vaults have unique ratios (e.g., ETH-A at 145%, WBTC-A at 145%).
• Aave & Compound: Use a Loan-to-Value (LTV) ratio, which is the inverse concept (e.g., 75% LTV equals a ~133% CR).
• The gap between a user's current CR and the liquidation threshold is the safety buffer or liquidation margin. A smaller buffer increases liquidation risk.

In protocols like Aave and Compound, the Health Factor serves a similar purpose to the collateralization ratio but is formatted differently.

• Formula: Health Factor = (Collateral Value × Liquidation Threshold) / Total Borrowed
• A Health Factor below 1.0 indicates an undercollateralized position eligible for liquidation.
• Users must monitor this value closely, as price volatility can cause it to drop rapidly.

Most DeFi lending requires overcollateralization, meaning the CR must be >100%. This is fundamental because:

• No Credit Checks: DeFi is permissionless and trustless.
• Price Volatility: Crypto assets are highly volatile; overcollateralization absorbs price swings.
• Liquidation Incentives: Provides a financial incentive (liquidation bonus) for liquidators to repay the debt and seize collateral during a liquidation event.

Borrowers must actively manage their CR to avoid liquidation.

• Increasing the CR: Can be done by depositing more collateral or repaying part of the debt.
• Automated Tools: Use DeFi dashboards (like DeBank, Zapper) or protocol-specific interfaces to monitor positions in real-time.
• Price Oracle Reliance: The CR calculation depends entirely on the accuracy and latency of the protocol's price oracles. Oracle manipulation is a key attack vector.

The collateralization ratio (CR) is a risk metric calculated as the value of a user's deposited collateral divided by the value of their borrowed debt, expressed as a percentage. It measures the safety buffer of a loan.

• Formula: (Value of Collateral / Value of Debt) × 100 = CR%
• Example: A user deposits $15,000 of ETH and borrows $10,000 of DAI. Their CR is ($15,000 / $10,000) × 100 = 150%. A higher ratio indicates a safer, less risky position.

Every lending protocol sets a minimum collateralization ratio, a critical threshold below which a position becomes eligible for liquidation. This is a key risk parameter.

• Typical Minimums: Vary by asset and protocol (e.g., 110% for volatile assets like ETH, 150% for more stable assets).
• Liquidation Trigger: If market volatility causes the CR to fall below this minimum, keepers or the protocol itself can liquidate the collateral to repay the debt, often incurring a liquidation penalty for the borrower.

In protocols like Aave, the inverse of the collateralization ratio is often expressed as a Health Factor (HF). It represents the safety margin against liquidation.

• Health Factor Formula: HF = (Collateral Value × Liquidation Threshold) / Total Borrowed
• Interpretation: An HF above 1.0 is safe. As it approaches 1.0, the risk of liquidation increases dramatically. Users must monitor this value closely, especially during market downturns.

Maintaining a high collateralization ratio is the primary method of risk management for borrowers. This practice is called overcollateralization.

• Action: Users can deposit more collateral or repay part of their debt to increase their CR.
• Purpose: Creates a larger buffer against price volatility, reducing the likelihood of a liquidation event. A common strategy is to target a CR significantly higher than the protocol's minimum requirement.

The minimum collateralization ratio is part of a suite of risk parameters set and managed by protocol governance or risk committees. These parameters are not static.

• Key Parameters: Loan-to-Value (LTV) ratio, liquidation threshold, and liquidation penalty.
• Dynamic Adjustment: Protocols may adjust these parameters for specific assets based on market volatility, liquidity, and oracle reliability to protect the solvency of the entire system.

The collateralization ratio is only as reliable as the price oracles that feed it data. Inaccurate pricing is a major systemic risk.

• Oracle Dependency: CR calculations depend on real-time price feeds from external oracles (e.g., Chainlink).
• Manipulation Vectors: Attackers may attempt oracle manipulation or flash loan attacks to artificially lower an asset's price, trigger unjust liquidations, and profit from the liquidation penalty.

The forced sale of a borrower's collateral when their collateralization ratio falls below the protocol's liquidation threshold. This process protects lenders from undercollateralized debt.

• Liquidation Penalty: A fee charged to the borrower during liquidation, paid to the liquidator.
• Liquidation Threshold: The specific ratio level that triggers the liquidation event, set lower than the minimum collateralization requirement to create a buffer.

A risk metric, popularized by Aave, that inversely represents the safety of a borrowing position. It is calculated as (Collateral Value * Liquidation Threshold) / Borrowed Value.

• A Health Factor above 1.0 indicates a safe position.
• A Health Factor equal to or below 1.0 makes the position eligible for liquidation.
• It dynamically updates with price fluctuations of the collateral and borrowed assets.

The lowest permissible collateralization ratio a borrower must maintain to avoid liquidation. It is a protocol-level parameter set by governance.

• For example, MakerDAO's MCR for an ETH-A vault is 145%.
• Borrowers must actively manage their ratio to stay above this floor.
• The MCR is a key determinant of a protocol's risk tolerance and capital efficiency.

The foundational security model where the value of locked collateral exceeds the value of the debt issued against it. A collateralization ratio greater than 100% signifies overcollateralization.

• This creates a safety buffer against asset volatility.
• It is the standard model for permissionless lending protocols like Maker and Compound.
• Contrasts with undercollateralized or uncollateralized lending.

The market price at which a borrower's collateral would be worth just enough to cover their debt at the liquidation threshold, triggering a liquidation event.

• Calculated as: (Borrowed Amount * Liquidation Threshold) / Collateral Amount.
• A critical price level for borrowers to monitor.
• For volatile assets, automated tools and alerts are often used to track this price.

The cost of borrowing, typically expressed as an annual percentage rate (APR). It is accrued on the debt and increases the outstanding loan balance.

• As debt grows from accrued interest, the collateralization ratio decreases if the collateral value remains static.
• In protocols like MakerDAO, this is called a Stability Fee.
• Borrowers must account for interest accrual when calculating their long-term collateral health.