Collateral

What Is Collateral?

Collateral is an asset that a borrower pledges to a lender to secure a loan. If the borrower fails to repay the loan, the lender can seize the collateral as compensation. In the world of cryptocurrency, collateral is often used in decentralized finance (DeFi) loans and trading. A simple example would be giving Ben $10 as collateral for borrowing his screwdriver for the day. If you fail to hand back the screwdriver, Ben gets to keep the $10.

How It Works

• Pledging an Asset: When you take out a loan, you put up collateral—something valuable like cryptocurrency, stocks, or real estate—that the lender holds as security. If you can’t repay the loan, the lender can take the collateral to cover their losses.
• Loan-to-Value (LTV) Ratio: The value of the loan you receive is usually a percentage of the collateral's worth. For example, if you pledge $1,000 worth of Bitcoin as collateral, you might get a loan worth 60% of that value ($600). If the value of your collateral drops, you may have to add more to avoid liquidation.
• Cryptocurrency Collateral: In the crypto world, people often use cryptocurrencies like Bitcoin or Ethereum as collateral to take out loans in stablecoins or other assets. This lets them hold onto their crypto while getting access to funds.

Example

Let’s say you want a loan of $5,000 in a DeFi platform, but instead of giving cash or property as collateral, you use Ethereum. You deposit $10,000 worth of Ethereum as collateral. If you can’t repay the loan, the platform can seize and sell your Ethereum to recover the money.

The reason they ask for double the crypto? Cryptocurrencies are volatile, and over-collateralization protects lenders from the risk of the collateral's value dropping below the loan amount.

If you can’t repay the loan, the platform can seize and sell your Ethereum to recover the $5,000. Additionally, if the value of your Ethereum drops significantly during the loan period, the platform may liquidate your collateral to protect itself, even before you default.

Key Takeaways

• Collateral is an asset pledged by a borrower to secure a loan.
• If the borrower fails to repay, the lender can seize the collateral to cover the loss.
• In crypto, assets like Bitcoin or Ethereum can be used as collateral for loans, allowing borrowers to access funds while holding onto their cryptocurrencies.

In short, collateral is a safety net for lenders and borrowers. You put up something valuable to get a loan, and if you can't repay, the lender takes the collateral as a form of repayment.