Collateralization
Collateralization is the use of an asset to secure a loan. In DeFi, it involves locking cryptocurrency into a smart contract to borrow other assets.
Concepts: 1. LTV (Loan-to-Value). 2. Liquidation Penalty. 3. Price [Oracle](/en/terms/price-oracle) dependency. 4. Re-hypothecation (using collateral to earn extra yield). Protocols: MakerDAO, Aave, Compound, Morpho. Risks: Oracle failure, Flash loan attacks on price, Cascading liquidations.
graph LR
Center["Collateralization"]:::main
Rel_htmlx["htmlx"]:::related -.-> Center
click Rel_htmlx "/terms/htmlx"
Rel_apache_http_server["apache-http-server"]:::related -.-> Center
click Rel_apache_http_server "/terms/apache-http-server"
Rel_http["http"]:::related -.-> Center
click Rel_http "/terms/http"
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linkStyle default stroke:#4b5563,stroke-width:2px;
🧒 Explain Like I'm 5
Collateralization is like going to a pawn shop. You give them your expensive watch (the [collateral](/en/terms/collateral)) and they give you a cash loan. If you don't pay the money back, or if the price of watches crashes and your watch isn't worth enough to cover the debt anymore, the shopkeeper keeps the watch. In [DeFi](/en/terms/defi), the 'shopkeeper' is a robot program that does this automatically.
🤓 Expert Deep Dive
Technically, the health of a collateralized position is defined by the 'Collateral Ratio' or 'Health Factor'. If the value of the collateral drops below the 'Liquidation Threshold', a third party (a Liquidator) can pay off the borrower's debt and take the collateral at a discount. This prevents 'Bad Debt' from accumulating in the protocol. Advanced systems like Aave use different 'Collateral Factors' (Loan-to-Value) for different assets; stablecoins have high factors (e.g., 85%), while volatile assets have lower ones (e.g., 60%). 'Cross-collateralization' allows a user to pool multiple assets to back a single loan, while 'Isolated' mode keeps the risk of one asset separate from the rest of the portfolio.