Collateralization ratio is an important metric in decentralized finance (DeFi) that signifies the financial soundness of a position in any lending or borrowing scenario. It is calculated as the total collateral value divided by the total borrowed value and expressed as a percentage. A higher collateralization ratio indicates a lower risk for lenders, as they are protected from default by having possession of assets in case the borrower defaults.

Overview

The Collateral Ratio is a measure used to determine the percentage of a borrower’s total value of collateral relative to the amount they wish to borrow. It’s calculated using the following formula:

Collateral Ratio = (Total Collateral Value / Total Borrowed Value) * 100%

This ratio is essential as it signifies the financial soundness of a position in any lending or borrowing scenario, especially in the realm of decentralized finance (DeFi).^[1]

Collateralization ratios can be different in centralized finance (CeFi) and decentralized finance (DeFi) systems.
In centralized finance (CeFi), collateralization ratios are typically determined by traditional financial institutions such as banks and are often subject to regulatory requirements. These ratios may vary depending on the type of loan or financial product and the risk assessment conducted by the financial institution. Banks may require a certain level of collateral to secure a loan, and this collateral can vary widely depending on the asset and the terms of the loan.
In decentralized finance (DeFi), collateralization ratios are often set by smart contracts and decentralized protocols. DeFi platforms use algorithms and code to determine collateralization requirements. These ratios can vary significantly from one DeFi protocol to another and are typically governed by the rules established within each protocol's smart contract. DeFi platforms often allow for greater flexibility and innovation in setting collateralization ratios, but they also come with their own unique risks and uncertainties.