Definition
Collateral provides a source of value against a loan, leveraged position or other obligation. In decentralized lending, users commonly deposit eligible crypto assets before borrowing. The protocol applies valuation rules and risk limits rather than treating every deposited token as equally reliable security.
How It Works
Borrowing capacity depends on recognized collateral value and the permitted loan-to-value ratio. A separate liquidation threshold may determine when third parties can repay debt in exchange for collateral under specified incentives. Falling collateral prices, rising debt value or accrued interest can weaken a position even when no new borrowing occurs.
Key Considerations
Collateral reduces some credit exposure but does not eliminate risk. Oracle errors, limited market liquidity, abrupt price moves or contract failures can prevent orderly liquidation. The deposited asset may itself be volatile or depend on an issuer. Depositors should distinguish the borrowing limit from the liquidation threshold and understand withdrawal restrictions. A collateral-backed product does not necessarily give every holder the same direct redemption or legal rights.