Collateral

Crypto collateral is managed by smart contracts, enabling automated, trustless operations. Key automated functions include:

• Automatic liquidation: If the collateral value falls below a predefined loan-to-value (LTV) ratio, the contract can automatically sell it to repay the loan.
• Real-time valuation: Collateral is priced via oracles that feed live market data on-chain.
• Permissionless access: Anyone can interact with the protocol to deposit or withdraw collateral, governed solely by code.

Due to high price volatility, crypto loans typically require overcollateralization. This means the value of the collateral deposited is greater than the value of the loan issued.

• Example: To borrow $1,000 of stablecoins, a user might need to lock $1,500 worth of ETH, resulting in a 150% collateral ratio.
• Liquidation Risk: If the collateral's value drops, the borrower must add more funds or face liquidation, where their collateral is sold at a discount to cover the debt.

Locked collateral can often be rehypothecated or put to work within the DeFi ecosystem, a concept known as "collateral efficiency."

• Yield-bearing collateral: Assets like staked ETH (stETH) or LP tokens can earn yield while being used as collateral.
• Collateral as a building block: The same collateral position can be used across multiple protocols (e.g., as collateral for a loan on Aave and then used in a yield strategy on Yearn), increasing capital efficiency but also systemic risk.

In principle, any on-chain token can be used as collateral, subject to a protocol's risk parameters. This creates a hierarchy of collateral types:

• Blue-chip collateral: Highly liquid, less volatile assets like ETH and wBTC are preferred and have favorable LTV ratios (e.g., 80%).
• Altcoin/long-tail collateral: More volatile or less liquid assets may be accepted at much lower LTV ratios (e.g., 40%) or require a safety module of more stable assets.
• Synthetic & LSTs: Derivatives like synthetic assets and liquid staking tokens expand the collateral universe.

All collateral positions are publicly verifiable on the blockchain. This enables:

• Real-time risk assessment: Anyone can audit the total value locked (TVL), collateral ratios, and health of the entire system.
• Proof of reserves: Protocols can cryptographically prove they hold sufficient collateral to back all issued liabilities.
• On-chain history: Every deposit, withdrawal, and liquidation is recorded immutably, providing a complete audit trail.

Collateral is no longer confined to a single blockchain. Cross-chain bridges and wrapped assets allow collateral to be ported between ecosystems.

• Examples: Wrapped Bitcoin (WBTC) on Ethereum, or bridged USDC from Ethereum to Avalanche.
• New risks: This introduces bridge risk—the smart contract securing the bridged assets becomes a critical point of failure. If compromised, the "collateral" on the destination chain may become worthless.

The Collateralization Ratio (CR) is the value of collateral relative to the borrowed amount. If the CR falls below a protocol's Liquidation Threshold due to price volatility, the position is subject to liquidation. This automated process sells the collateral, often at a discount, to repay the debt, potentially resulting in a loss for the borrower.

• Example: A 150% CR means $150 of ETH collateral for a $100 DAI loan.
• Risk: A sharp market drop can trigger mass liquidations, creating a cascade.

DeFi protocols rely on price oracles (e.g., Chainlink) to determine collateral value. If an oracle provides stale or manipulated data, it can cause incorrect liquidations or allow undercollateralized borrowing.

• Manipulation Vectors: Flash loan attacks can temporarily skew prices on a DEX that feeds an oracle.
• Mitigation: Protocols use time-weighted average prices (TWAPs) and multiple data sources.

Not all collateral is equal. Volatile assets (e.g., memecoins) require higher overcollateralization. Illegitimate assets pose existential risks.

• Volatility: A stablecoin loan backed by a volatile token is highly risky.
• Illegitimacy: Collateral could be a malicious token with a backdoor (e.g., a fake "staking" contract that lets the creator drain it).
• Protocols carefully curate whitelists for collateral assets.

The collateral is locked in a smart contract. Vulnerabilities in this contract (e.g., logic errors, upgrade mechanisms) can lead to total loss. Furthermore, some cross-chain or wrapped asset systems introduce custodial risk with trusted intermediaries.

• Examples: The 2022 Nomad Bridge hack resulted in the loss of user collateral.
• Due Diligence: Audits and bug bounties are critical, but not guarantees.

During liquidation, the collateral must be sold. If the market lacks liquidity for that asset, the sale incurs high slippage, worsening the loss. The liquidation penalty may not cover this shortfall, potentially leaving the protocol with bad debt.

• Consequence: The protocol's solvency depends on liquidators being able to profitably execute.
• Design Factor: Protocols model liquidation incentives and slippage tolerances.

Using collateral bridged from another blockchain (e.g., wBTC, cross-chain stablecoins) adds layers of risk. The user is exposed to the security of both the source chain and the bridge validating the transfer.

• Bridge Hacks: Are a predominant source of major DeFi losses (e.g., Ronin, Wormhole).
• Wrapped Assets: Represent a claim on an asset held elsewhere, relying on the wrapper's integrity.

Liquidation is the forced sale of a borrower's collateral when their collateralization ratio falls below a predefined threshold. This process protects lenders from undercollateralized loans.

• Triggered by keepers or automated bots who repay the outstanding debt in exchange for the collateral at a discount.
• The liquidation penalty is an additional fee paid by the borrower.
• Protocols like Aave and Compound use dynamic liquidation thresholds and health factors to manage this risk.

Overcollateralization is the practice of pledging collateral worth more than the loan value. It is the dominant model in DeFi to mitigate counterparty risk and price volatility in the absence of credit checks.

• For example, to borrow $100 of DAI, a user might need to lock $150 worth of ETH.
• This excess value acts as a safety buffer.
• It contrasts with undercollateralized or uncollateralized lending, which relies on creditworthiness or other mechanisms.

In DeFi, collateral is not limited to a single asset. Protocols accept a variety of tokenized assets, each with different risk profiles.

• Volatile Assets: Native cryptocurrencies like ETH and wBTC. High volatility requires higher overcollateralization.
• Stablecoins: Other pegged assets like USDC can be used as collateral, often with a lower liquidation threshold.
• Liquid Staking Tokens (LSTs): Tokens like stETH or rETH that represent staked assets and accrue yield.
• Real-World Assets (RWAs): Tokenized versions of traditional finance assets like treasury bills or real estate.

Collateral-backed stablecoins are cryptocurrencies pegged to a flat currency (like USD) and backed by on-chain collateral reserves.

• DAI is the canonical example, an overcollateralized, decentralized stablecoin backed by a basket of crypto assets.
• USDC and USDT are fiat-collateralized stablecoins, where reserves are held off-chain by centralized entities.
• The type and quality of collateral directly impact the stability, decentralization, and credit risk of the stablecoin.