Collateral

Collateral is an asset you lock up to get a loan or open a position. If you fail to repay or the price moves against you, the collateral can be sold.

How it works

Collateral protects whoever lends to you. In DeFi it is the tokens you deposit into a smart contract before borrowing. On a leveraged exchange position, your margin is the collateral. It also backs some stablecoins, which are issued against crypto locked in a contract.

In crypto you almost always need more collateral than you borrow, because prices swing hard. The ratio of loan to collateral is called LTV (loan-to-value). At 50% LTV, $2,000 of collateral lets you borrow $1,000.

If the collateral's value drops to a threshold, part or all of it is sold. That is liquidation. The more volatile the collateral, the lower the allowed LTV. Stablecoins are steadier collateral, but they can also lose their dollar peg.

Example with numbers

A protocol requires 150% collateral. To borrow 1,000 USDC you deposit $1,500 of ETH. If ETH falls 20%, your collateral is worth $1,200, the ratio drops to 120%, and if the liquidation threshold is, say, 125%, part of it is already being sold.

Common mistake

A common mistake is locking up everything you own and borrowing the maximum. One sharp crash and the collateral is sold with a penalty. Leave a large buffer, watch the collateral price, and keep spare funds ready to top it up if prices fall.

Questions and answers

What is collateral in crypto in simple terms?

It is coins you lock as a guarantee that you will repay a loan. If you cannot cover the debt, they get sold.

Why is crypto collateral bigger than the loan?

Prices can drop by tens of percent in a day. The buffer keeps the debt covered anyway.

What is LTV?

It is the loan amount divided by the collateral value. The higher the LTV, the closer you are to liquidation.

Collateral

How it works

Questions and answers

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