To borrow assets in DeFi, users must over-collateralize their loans. The essence of this over-collateralization is to ensure the security and stability of loans. In traditional lending, collateral might be just enough to cover the loan amount, such as using a house to secure a mortgage. However, due to the volatile nature of cryptocurrencies, DeFi platforms often require users to over-collateralize their loans, meaning the value of the collateral must exceed the value of the loan.
In DeFi lending, the collateral factor (also known as the loan-to-value ratio, or LTV) is a critical metric that determines how much a borrower can take out as a loan relative to the value of their collateral. The collateral factor is expressed as a percentage and directly impacts the lender's margin of safety.
In DeFi lending, the collateral factor (also known as the loan-to-value ratio, or LTV) is a critical metric that determines how much a borrower can take out as a loan relative to the value of their collateral. The collateral factor is expressed as a percentage and directly impacts the lender's margin of safety.
Collateral Factor and Margin of Safety
The collateral factor is the maximum loan value that can be taken out against the collateral's value. A lower collateral factor means a smaller portion of the collateral's value can be borrowed, which provides a higher margin of safety for the lender.
Higher Collateral Factor: Allows borrowers to take out larger loans relative to their collateral. For example, a 75% collateral factor means a borrower can take out a loan worth up to 75% of the value of their collateral. A higher CF is typically used for less volatile assets.
How Collateral Factor Works
Allowed Loan Amount = Collateral Value×Collateral Factor
For example, if the collateral factor is 75%, a borrower can take out a loan up to 75% of the value of their collateral. If the collateral is worth $10,000, the maximum loan amount would be:
Loan Amount = $10,000×0.75= $7,500
A lower collateral factor means a borrower can take out a smaller loan relative to their collateral, providing a higher margin of safety for the lender.
Collateral Ratio
The collateral ratio measures the current state of the loan relative to the value of the collateral. It is expressed as a percentage and represents how much of the collateral's value is currently securing the loan. It continuously changes based on fluctuations in collateral value and loan repayment.
Collateral Ratio = Collateral Value/Loan Value
Imagine you want to borrow $100 worth of DAI. The DeFi platform requires a collateral ratio of 150%. This means you need to deposit collateral worth at least 150% of the loan amount to secure the loan.
For a $100 loan, the required collateral value is:
Collateral Value = Loan Value × Collateral Ratio
Collateral Value = $100x1.5 = $150
Liquidations in DeFi
Liquidation occurs when a DeFi platform sells a borrower's collateral to repay the loan when the collateral's value falls below a specified threshold. This mechanism protects lenders from potential losses due to the collateral's volatility.
Continuing with our example,
If 1 ETH is worth $2000, you need to deposit__ 150/2000 = 0.075 ETH
Suppose the price of ETH drops to $1200. The value of your 0.075 ETH collateral is now: 0.075×1200=$90.
Now, the Collateral Ratio= Collateral Value/Loan Amount×100 = 90/100 ×100 = 90%
Liquidation threshold Explained
The agreed threshold (or liquidation threshold) is the minimum collateral ratio required to keep a loan healthy and avoid liquidation. Let us say the liquidation threshold was 100%. The example above shows that liquidation would have been triggered long before the C.R of 90%.
When the collateral ratio drops below the threshold, the DeFi platform initiates liquidation to protect the lender's funds.
Here's how the liquidation process works:
When liquidation is triggered, the platform sells enough collateral to cover the loan amount and a liquidation penalty.
