What is Over-Collateralization?
Over-collateralization is a risk management strategy widely used in decentralized lending and borrowing platforms within the DeFi ecosystem. It involves borrowers providing collateral that exceeds the value of the loan they wish to secure. This practice safeguards lenders against potential defaults, given the volatility often associated with cryptocurrency assets.
In a typical over-collateralized loan, a borrower must deposit collateral, such as Ethereum or stablecoins, that is worth more than the amount they intend to borrow. For instance, if a user wishes to borrow $100 worth of a token, they may need to supply $150 worth of collateral. This mechanism mitigates risk as it ensures that even if the value of the collateral falls, the lender's exposure is minimized.
Over-collateralization also plays a significant role in the mechanics of decentralized finance platforms like Aave, MakerDAO, and Compound. By requiring excess collateral, these platforms maintain solvency and financial security, ultimately fostering trust in the decentralized lending space.
While over-collateralization aids in protecting lenders, it can pose challenges for borrowers, as they must lock up more capital than they receive in loans. This can limit the accessibility of liquidity for some users and highlights the balance between risk management and capital efficiency within DeFi.