What Is Collateralization in Crypto?
When you ask your local bank for a loan, the bank requires you to pledge some valuable assets or securities of relatively equal (or greater) value to reassure against default risks. The assets pledged, also known as collateral or security, can be in the form of a traditional financial or physical asset, such as an investment account, car, or land. The bank (lender) can claim and liquidate the collateral to offset the debt if the borrower defaults on repayment. This process of securing a loan using collateral is called collateralization.
In the crypto context, collateralization is the process of locking up digital assets to borrow funds or participate in blockchain network operations. This practice is more common in decentralized finance (DeFi) protocols.
Since blockchains lack a central authority to vet and issue loans, the process requires the borrower to lock up a certain amount of their cryptocurrency assets as collateral in a smart contract. The collateral amount usually exceeds the value of the requested loan to protect the lender against crypto price volatility.
So if the borrower defaults on the crypto loan, or when the collateral’s value drops below the predetermined threshold due to price volatility, the smart contract automatically initiates collateral liquidation. The collateral is liquidated to settle the loan amount plus interest, protecting the lender against any losses arising from market movements or borrower defaulting. Most DeFi lending platforms resort to collateral tokens and stablecoins tied to fiat money as collateral to alleviate abrupt price shifts.
Collateralization in margin trading allows traders to use their crypto assets to access extra funds, known as leverage, to amplify their buying or selling power. This also faces liquidation risks when the market moves against the trader.