Collateral

Collateral is the asset a borrower pledges to a lender as a guarantee of repayment, and in crypto it takes on a distinct role because there is no credit score or legal identity backing a loan on a public blockchain.

Instead of trusting the borrower, most crypto lending protocols trust the collateral itself. A user locks up a volatile asset such as ETH in a smart contract and receives a loan, usually in a stablecoin, worth less than the deposit. This practice, called overcollateralization, protects the protocol if the market moves against the borrower. Requiring $150 of collateral for every $100 borrowed, for example, gives the system a buffer before the loan turns "underwater."

Each collateral type carries a loan-to-value (LTV) ratio and a separate liquidation threshold. If the collateral's value falls and the loan-to-collateral ratio crosses that threshold, smart contracts, fed by price oracles, automatically trigger a liquidation: part or all of the collateral is sold, or auctioned as with MakerDAO's Collateralized Debt Position vaults, to repay the debt plus a penalty. This process is central to DeFi lending markets and to margin trading, where posted collateral determines how much leverage a trader can access.

Collateral also appears outside lending: many blockchains require operators to stake or lock tokens as collateral to run a masternode or validator, aligning their financial interest with honest behavior. Because crypto prices swing sharply, choosing volatile assets as collateral always carries liquidation risk, especially during fast market crashes when oracle prices and available liquidity can lag the sell-off.