Collateralization

Editorial Chief

Author

December 05, 2023

Published

Collateralization is the process of using a valuable asset as security for a loan. In decentralized finance (DeFi), collateralization involves depositing cryptocurrency assets as collateral to borrow other cryptocurrencies or assets. This process allows users to access liquidity without having to sell their holdings.

 

How Collateralization Works

 

  • User deposits collateral: The user deposits cryptocurrency assets into a DeFi protocol as collateral.
  • Borrower receives loan: The borrower receives a loan in the form of cryptocurrency or other assets.
  • Collateral locked up: The deposited collateral is locked up in the DeFi protocol as security for the loan.
  • Liquidation risk: If the value of the collateral drops below a certain threshold, the protocol may automatically liquidate the collateral to recoup its losses.

 

Benefits of Collateralization

 

  • Access liquidity: Collateralization allows users to access liquidity without selling their holdings.
  • Earn interest: Users can earn interest on their deposited collateral while their loans are outstanding.
  • Avoid capital gains taxes: By borrowing instead of selling, users can avoid paying capital gains taxes on their cryptocurrency holdings.

 

Risks of Collateralization

 

  • Liquidation risk: If the value of the collateral drops too much, the protocol may liquidate the collateral, resulting in a loss for the borrower.
  • Interest rate risk: The interest rate on the loan may fluctuate, which could increase the cost of the loan.

 

Examples of Collateralization in DeFI

 

  • Aave: Aave is a popular DeFi lending protocol that allows users to borrow and lend a variety of cryptocurrencies.
  • Compound: Compound is another popular DeFi lending protocol that offers interest-earning deposits and borrowing opportunities.
  • MakerDAO: MakerDAO is a decentralized stablecoin protocol that uses collateralized debt positions (CDPs) to issue its stablecoin, DAI.

 

Understanding collateralization is essential for web3 beginners who want to participate in DeFi lending and borrowing. It allows them to leverage their existing cryptocurrency holdings to access liquidity and earn yield without selling their assets.