What is collateralization in DeFi?

Typically, if you’re borrowing assets, you need to put up collateral to cover your loan. This essentially acts as insurance for your loan. How is this relevant? This depends on what protocol you’re supplying your funds to, but you may need to keep a close eye on your collateralization ratio.

If your collateral’s value falls below the threshold required by the protocol, your collateral may be liquidated on the open market. What can you do to avoid liquidation? You can add more collateral.

To reiterate, each platform will have its own set of rules for this, i.e., their own required collateralization ratio. In addition, they commonly work with a concept called overcollateralization. This means that borrowers have to deposit more value than they want to borrow. Why? To reduce the risk of violent market crashes liquidating a large amount of collateral in the system.

So, let’s say that the lending protocol you’re using requires a collateralization ratio of 200%. This means that for every 100 USD of value you put in, you can borrow 50 USD. However, it’s usually safer to add more collateral than required to reduce liquidation risk even more. With that said, many systems will use very high collateralization ratios (such as 750%) to keep the entire platform relatively safe from liquidation risk.