Collateral refers to an asset offered by a borrower to a lender as a security measure while obtaining a loan. Collateral is used in crypto to reduce the risk of lending and borrowing digital assets. ^[1][2]

Overview

Collateral is a term used by people who want to borrow money or other valuable assets from a financial institution, such as a bank, lending institute, or other related organizations. ^[8] As a risk reduction measure for the lender, the borrower pledges a specific amount of cryptocurrencies as collateral. In the event of the borrower's failure to repay the loan, the lender has the authority to seize the cryptocurrency deposited as collateral.

In the realm of traditional finance (TradFi), there are two main loan types: secured loans and unsecured loans. Secured loans involve providing an asset as collateral to ensure repayment security. In contrast, unsecured loans do not require collateral.^[3] In crypto, there are different ways to use collateral, depending on the platform and the type of loan. Some platforms allow borrowers to use Bitcoin or Ethereum as collateral, while others require specific tokens (collateral tokens) designed for collateralization, such as COLL. ^[7]

Decentralized Finance (DeFi) places a stronger emphasis on secured lending. While it does offer unsecured loans like flash loans, the majority of users tend to favor secured loans, which can be obtained by providing crypto assets as collateral.

Collateralization in DeFi

Collateralization in decentralized finance is not entirely different from that of traditional finance, except that the former is automated using smart contracts which replace the intermediaries and risky functions found in the traditional financial system. Through the mechanism of smart contracts, users can secure loans or conduct various financial transactions by depositing their cryptocurrencies as collateral. This approach enables a decentralized and efficient way for individuals to access financial services using their digital assets. Collateralized loans are viewed as the backbone of open lending protocols in DeFi.^[3]

The process of collateralization in cryptocurrency operates in the same way as in traditional finance. Hence, when borrowing cryptocurrency from a lender, the borrowers are required to deposit a predetermined quantity of tokens to obtain an equivalent quantity of a different token such as BTC or ETH. The deposited token is referred to as the collateral token.^[4]

In DeFi, a borrower interacts with a lending protocol and borrows from a liquidity pool which consists of investments made by people who can otherwise be described as lenders. Just as in TradFi, a borrower must stake a specific amount in order to be able to access a loan from the liquidity pool.^[8]

Most DeFi lending protocols offer overcollateralized loans, meaning that the borrower must supply more collateral than the amount they borrow, to account for the volatility of crypto prices. Other platforms use undercollateralization, meaning that the borrower can borrow more than their collateral, but they need to meet certain criteria, such as having a good credit score or a verified identity.^[6]

The community of decentralized finance stablecoin protocol Frax Finance has voted to fully collateralize its native stablecoin Frax (FRAX), marking an end to the algorithmic backing of the protocol. The FIP-188 governance proposal — which would change the collateralization model of FRAX — initially posted on Feb. 15, 2023, reached a quorum with 98% voting in favor as of Feb. 23, 2023. The proposal read,

“The time has come for Frax to gradually remove the algorithmic backing of the protocol.”

The original protocol included a “variable collateral ratio” that was adjusted based on the market demand for the stablecoin. The market would dictate how much collateral was required for each FRAX to equal one United States dollar. The hybrid model resulted in the stablecoin being 80% backed by crypto asset collateral and partially stabilized algorithmically. This was achieved by the minting and burning of its governance token, FXS. Following the implementation of the proposal FIP-188, the protocol does not mint any more FXS to increase the collateral ratio and token supply. It plans to retain protocol revenue to fund the increased collateral ratio, which includes pausing FXS buybacks.^[11][12][13]

Such lending obligations include the amount repayable including capital and interest, loan duration, repayment plan (if available), and so on.

Minimum Collateralization Ratio (MCR)

The minimum collateralization ratio (MCR) is the minimum amount of cash or its equivalent pledged as security for returning a loan. The type of fund is the main element in determining the minimum collateralization ratio requirement. It’s important to note that the MCR is a legal requirement.^[9]

The MCR is used to protect the integrity of the market and reduce the risk of default. The higher the MCR, the more collateral is required to borrow money or other assets. The lower the MCR, the less collateral is needed, but the higher the risk of liquidation.

The MCR varies depending on the type of fund and the type of collateral. For example, some decentralized finance (DeFi) platforms use cryptocurrencies as collateral to issue stablecoins or lend other cryptocurrencies. These platforms have different MCRs for different types of collateral, depending on their volatility and liquidity. For example, MakerDAO has an MCR of 150% for ETH and 175% for WBTC. This means that if someone wants to borrow 100 DAI using ETH as collateral, they need to deposit at least 150 ETH. If the value of ETH drops below a certain threshold, their position will be liquidated and they will lose their collateral.^[10]

The MCR is not a fixed value but can change over time depending on market conditions and governance decisions. For example, MakerDAO can adjust its MCR through its decentralized autonomous organization (DAO) mechanism, where MKR token holders can vote on various parameters of the system. This allows the platform to adapt to changing market dynamics and optimize its risk management.

The MCR is one of the key metrics that borrowers and lenders should consider when using crypto-backed loans. It affects the borrowing capacity, the interest rate, and the liquidation risk of a loan. Borrowers should aim to maintain a healthy collateralization ratio above the MCR to avoid liquidation and benefit from lower interest rates. Lenders should monitor the MCR and the collateral value of their loans to ensure they are adequately secured and profitable.

Collateral Tokens / Coins

Collateral token is a general term that refers to any crypto asset that can be used as security for a loan or as collateral in a decentralized lending platform. On the other hand, Collateral coin refers to a specific type of crypto asset that is designed for collateralization, such as COLL.

Collateral tokens are a type of crypto asset that can be deposited as security for a loan or as collateral in a decentralized lending platform. The value of the collateral tokens serves as a guarantee that the borrower will repay the loan. If the borrower fails to do so, the lender can liquidate the collateral tokens to recover their funds.

Collateral coins may have additional features or benefits, such as allowing holders to pay for goods and services in fiat, participating in governance, or accessing other DeFi applications. However, not all collateral tokens are collateral coins, and not all collateral coins are suitable for every platform or loan type. Therefore, borrowers and lenders should carefully research the collateral requirements and options before using collateral in crypto.

NFT as Collateral

NFTs can be used as collateral to obtain a loan from some platforms that offer crypto-backed lending services. This means that the borrower can borrow cryptocurrency by using their NFT as security for returning the loan. However, there are some risks and challenges involved in using NFTs as collateral, such as valuation, liquidation, and custody.^[14]

• Valuation: NFTs are often hard to value due to their uniqueness and lack of liquidity. There is no standard way to appraise the worth of an NFT, and the market price can fluctuate significantly depending on supply and demand. Therefore, it can be difficult to determine how much a borrower can borrow or lend using an NFT as collateral.
• Liquidation: NFTs are subject to liquidation risk if the value of the collateral drops below a certain threshold or the borrower fails to repay the loan on time. In that case, the lender can seize the NFT and sell it to recover their funds. However, finding a buyer for an NFT can be challenging, especially in a bear market or for niche items. Therefore, lenders may require a higher interest rate or a lower loan-to-value ratio (LTV) to mitigate this risk.
• Custody: NFTs are stored on a blockchain, which means that they are controlled by a private key. When anyone uses an NFT as collateral, they have to transfer it to a smart contract or a third-party custodian that acts as an escrow agent. This means that they lose access and ownership of their NFT until they repay the loan and reclaim it. Therefore, they have to trust the platform or the custodian that they will not lose or misuse their NFT.

Some of the platforms that offer NFT-backed lending services are:

• NFTfi: A peer-to-peer platform that allows users to borrow and lend cryptocurrency using NFTs as collateral. Users can list their NFTs, set their desired loan terms, and receive offers from other users. The platform supports various types of NFTs, such as art, gaming, sports, and metaverse items. The platform charges a 0% fee for borrowers and a 2% fee for lenders.

• Rocket: A decentralized platform that enables users to borrow stablecoins using NFTs as collateral. Users can deposit their NFTs into a vault and mint stablecoins based on the appraised value of their NFTs. The platform uses a network of appraisers to determine the value of each NFT and adjust it over time. The platform charges a 1% origination fee and a 5% liquidation fee.^[15]
• Nexo: A centralized (CeFi) platform that provides instant loans using NFTs as collateral. Users can deposit their NFTs into a secure wallet and receive up to 50% of their value in fiat or crypto. The platform accepts various types of NFTs, such as art, music, gaming, and sports items. The platform charges an interest rate starting from 6.9% per year.^[16]