Collaterization ratio is a term used in cryptocurrency to describe the relationship between the value of the collateral used to secure a loan and the loan amount. It is calculated by dividing the collateral value by the loan value. A collateralization ratio greater than one indicates that the loan is overcollateralized. ^[1][2]

Overview

Collateralization in cryptocurrency refers to the practise of using one crypto asset as security to obtain a loan. In the event of a loan default, the lender has the right to take possession of the asset and sell it in order to recover their financial loss. The process of collateralizing assets offers lenders a sense of security in mitigating the risk of default. Loans can be made accessible to borrowers with poor credit histories. ^[5]

The collateralization ratio (also known as Collateral Coverage Ratio) is a metric used to assess the proportion of a loan compared to the value of the collateral supporting it. The collateral serves as security for the loan. A higher proportion in this context reduces the risk associated with the transaction for the lender. This is due to the lender's protection against default, as they possess assets that can be used to cover any losses in the event of borrower default. ^[6]

Lenders use collaterization ratio as a metric to determine the appropriate amount of crypto assets to lend to a borrower. The lender can also calculate the loan-to-value ratio (which is a risk indicator) from the collaterization ratio. ^[6]

Collaterization ratio is calculated using the formular:

Collaterization in DeFi

Collateralization in decentralized finance shares similarities with traditional finance, but with the key distinction of automation through smart contracts. These smart contracts eliminate the need for intermediaries and mitigate the risks associated with certain functions in the traditional financial system. Collateralized loans play a crucial role in open lending protocols within the realm of decentralized finance (DeFi). ^[7]

In decentralized finance (DeFi), a borrower engages with a lending protocol, a system designed for facilitating borrowing activities. The borrower obtains funds from a liquidity pool, which comprises investments contributed by individuals commonly referred to as lenders. Similar to traditional finance (TradFi), a borrower is required to deposit a specific amount as collateral in order to obtain a loan from the liquidity pool. ^[7]

With the exception of a few instances, the majority of DeFi lending protocols provide loans that require borrowers to stake collateral worth more than the amount they intend to borrow from the liquidity pool (overcollaterization). The collateral amount required from a borrower can vary depending on the protocol, typically ranging from 100% to 300% of the borrowed amount.^[7]

In order to understand the rationale behind the higher collateral ratio in DeFi, it is important to acknowledge the inherent volatility of most cryptocurrencies available in the market. The implication of this is that in certain cases, a lender may experience a financial loss despite the borrower repaying the loan along with the accrued interest. This situation typically arises when the borrowed asset experiences a substantial increase in value during the given time frame. ^[7]

Different lending protocols apply varying collateral ratios and liquidity penalties to address this issue. These measures typically prioritize the investor (i.e., lender) by providing favourable conditions. In Maker DAO, for instance, a collateral amount equivalent to 150% of the borrowed amount is typically charged. ^[7]

Overcollaterization

Overcollateralization refers to the condition in which the value of the crypto asset (or assets) used as collateral for a loan surpasses the value of the loan itself. Borrowers often use this to improve the credit rating of the loan and lower the credit risk for the lender. ^[3][4]

Overcollateralization is a credit improvement strategy that lowers the credit risk that the creditor is exposed to. Credit risk is avoided by posting collateral with a value larger than the loan value since the lender may sell the collateral to cover any possible loan losses. In this case, the collateral ratio is greater than 1.^[1]
Overcollaterization is beneficial for potential high-risk borrowers, such as individuals with poor credit or limited borrowing history. Borrowers might raise their chances of getting a loan authorized by putting up more collateral than is necessary. Additionally, lenders can be more inclined to provide borrowers with better conditions if they overcollateralize their loans.^[8]