Collateralization

Collateralization works by requiring a borrower to lock up an asset worth more than the loan or synthetic token they receive in return, so the lender or protocol has a buffer to absorb price swings before ever taking a loss. The ratio between the two values, expressed as a percentage, is what protocols track continuously to decide whether a position remains safe.

Because blockchains have no credit scores or courts to chase down defaulters, DeFi lending markets like Aave and Compound substitute trust with math: a borrower depositing ETH or another volatile asset can typically draw a loan worth only 60-80% of that collateral's value, a limit known as the loan-to-value ratio. A separate, higher liquidation threshold marks the point where the position becomes unsafe. If the collateral's market price falls and the ratio breaches that threshold, automated liquidators or auctions step in, sell part of the collateral, repay the debt, and charge the borrower a penalty, usually 5-10% of the position.

Stablecoin issuers such as Sky (formerly MakerDAO) apply the same logic through a Collateralized Debt Position, where users lock crypto, often ETH, and mint a dollar-pegged token against it, typically keeping the ratio above 150% to survive sharp drawdowns.

The core trade-off is capital efficiency versus safety: higher collateral requirements make cascading liquidations less likely but tie up more capital per dollar borrowed, which is why ratios vary widely by asset and protocol risk appetite.