Collateral
In simple terms
Collateral is what you lock up so you can borrow. If its value drops too far, the protocol sells it automatically to repay the loan, and you do not get a phone call first.
Definition
Assets pledged to secure a loan, which can be sold by the protocol if the loan falls below its required backing.
In depth
On-chain lending is secured by assets deposited into a contract, with borrowing capacity determined by a per-asset loan-to-value ratio reflecting that asset's volatility and liquidity. Health is tracked continuously against oracle prices. When the position crosses the liquidation threshold, anyone may repay part of the debt and claim collateral at a discount — the liquidation bonus — which is what makes liquidation permissionless and near-instant rather than a process with notice periods.
How does Collateral work?
A borrower deposits collateral and draws a loan below the permitted ratio. The protocol recomputes the position's health on every price update. If the collateral falls or the debt grows past the threshold, liquidators compete to repay the debt and take collateral plus the bonus. The borrower keeps the borrowed funds and loses the liquidated collateral, so a liquidation is a realised loss rather than a missed opportunity.
An example
Someone deposits an illustrative $10,000 of ETH at a 75 percent loan-to-value limit and borrows $5,000 in stablecoins. If ETH falls far enough that the collateral is worth about $6,250, the position reaches an 80 percent liquidation threshold and part of the collateral is sold at a discount to bring it back within limits.
Figures are illustrative only.
What beginners get wrong
- Borrowing to the maximum. A position opened at the limit is one ordinary price move from liquidation.
- Expecting a margin call. There is no warning and no grace period; liquidation is automated and permissionless.
- Using volatile collateral to borrow more of the same asset, which compounds the exposure in both directions.
- Ignoring accruing interest, which raises the debt over time and can trigger liquidation with no price move at all.
Related terms
Part of
What is DeFi, and how does decentralized finance work? — the subject page for defi, with all 18 of its definitions in one place.
Educational only — not financial advice.