Collateral

What is Collateral?

Collateral is an asset provided by a borrower as security for a loan. If the borrower cannot repay the loan, the lender (or protocol) can seize and sell the collateral to recover the funds.

How does Collateral work?

1. A user deposits an accepted asset (like ETH or WBTC) into a smart contract.
2. The contract calculates the borrowing power based on the collateral's value.
3. The user receives the borrowed assets while the collateral remains "locked."
4. If the loan is repaid with interest, the collateral is returned to the user.
5. If the collateral's value drops too much, it is automatically sold (liquidated) to cover the debt.

Why does Collateral matter?

Collateral enables "trustless" lending on the blockchain. Since protocols cannot use credit scores or legal enforcement, they rely on the immediate value of locked assets to ensure that lenders are always paid back.

Key features of Collateral

• Backing for a loan
• Usually requires "overcollateralization" in DeFi
• Locked in a smart contract
• Subject to liquidation risk
• Determines the amount that can be borrowed

Examples of Collateral

• Using ETH as collateral to borrow a stablecoin like USDC.
• Depositing "Liquid Staking Tokens" (like stETH) to gain leverage in a DeFi strategy.
• A DAO using its own treasury tokens as collateral to fund operations.