Overcollateralization is a key mechanism underlying borrowing and lending in DeFi. Borrowers post collateral to access loans, which are set up as overcollateralized schemes. This means that the asset value deposited by a borrower must be higher than the loan amount he receives.
This practice protects traders from the often extreme price swings that characterize cryptocurrency markets. Over-collateralized positions allow borrowers to build a cushion that protects liquidity providers and lenders in case the value of the collateral suddenly plummets.
How to build an overcollateralized position on a trading platform
Let’s say someone is concerned about inflation hitting the US dollar. They can deposit a cryptocurrency of their choice, borrow US dollars, exchange the USD for that crypto and deposit it back into the lending dApp. In this way, they take a bearish position on the dollar while increasing their exposure to crypto assets.
If their prediction comes true and an inflation spike occurs, the price of the crypto asset should increase by at least the inflation amount, while the US dollar amount remains constant. The trader can use the profits on the borrowed crypto to repay the loan in US dollars and still keep the crypto and the profits from the original crypto deposit.
Let’s look at a practical example. After choosing a platform that allows over-collateralization, a trader can deposit ether worth $1,500 and borrow USDC for $500, which equates to a 300% collateral ratio. If the price of ether falls significantly, there is a 150% buffer before the liquidation threshold is reached.
Platforms typically accept ether, Bitcoin or stablecoins. Stablecoins are less volatile than other cryptocurrencies, which is one of the reasons they are attractive to institutional lenders. In addition, their value is easier to predict, making them more suitable for lending as this reduces the risk associated with assessing the value of collateral.
Platforms like Dolomite offer tools that have become an integral part of modern lending systems. Some of these instruments continuously assess the liquidity of collateral assets, allowing lenders to monitor collateral values and market conditions in real time.
In DeFi lending, the over-collateralization ratios serve as crucial metrics that determine the value of the collateral required against the loan amount. They are always above 100% to protect the trader from market volatility. Each platform determines these ratios based on historical volatility data, market conditions and the perceived risk of the collateral type. If the platform establishes a collateral ratio of 150%, the trader must provide an asset worth at least 150% of the loan amount. They can then exceed the minimum ratio that requires overcollateralization by providing collateral worth 200% or more of the loan amount.
Fully automated lending will soon become a reality
The process of borrowing assets will become fully automated in the near future with Dolomite’s new “Zap” feature. Increasing leverage on an asset by borrowing against it and then buying it is quite annoying. Posting collateral, borrowing against it, withdrawing from the platform, getting more collateral and depositing it, borrowing again, and so on until the desired leverage is achieved will all be reduced to a single step. Zap will also make it possible to use collateral to pay off debt in a position instead of unwinding a borrowing position by reversing the loop process. Zap will use a DEX aggregator to execute these trades, and users will not experience any liquidity issues.
Margin traders should open a leveraged position. The amount they can borrow depends on the platform’s loan-to-value ratio. A ratio of 45% means that they can borrow up to 45% of the collateral deposited. If the value of the borrowed asset increases or the value of the collateral decreases, the position can be liquidated. To avoid this, traders should check the ratio regularly. The trader repays the loan plus any fees or interest to close the position. They withdraw their collateral once the loan is repaid.
The bad and the ugly
Let’s say a trader puts up ether worth $20,000 as collateral to borrow USDT worth $1,000. This is a classic example of inefficient over-collateralization, where the 2000% ratio is significantly higher than the typical requirement of 150-200%. The trader holds a large amount of capital without utilizing it effectively.
Using a borrowed asset as collateral is even riskier and less efficient. It seems counterintuitive, but a trader can borrow an altcoin worth $5,000 against ether worth $10,000. They re-deposit the altcoin as collateral to borrow more ether. The use of a borrowed asset to secure further credit risk. If the value of the borrowed asset declines, this will lead to multi-tiered liquidation.
Borrowing, re-depositing and re-borrowing comes with high fees and interest rates, eating into any profits. The user is ultimately exposed to both the volatility of the collateral and the performance of the borrowed asset, doubling the risk. A drop in the price of collateral or borrowed assets could wipe out all the seed capital in a downright ugly scenario.
Opportunities that go beyond lending and borrowing
Dolomite only allows margin and spot trading of ETH-USDC, but once it integrates the aggregator, users will be able to trade virtually any asset with external liquidity, eliminating the risk of slippage and limited markets. It offers margin trading on assets not available elsewhere.
Users can deposit ether and USDC and earn interest on loans, then add these assets to a liquidity pool and earn trading fees. They can make money by lending the USDC-ETH liquidity pool token. Furthermore, with the integration of Dolomite into Berachain through the Royco Pre-Deposit Campaign, users will have even more opportunities to maximize capital efficiency. Berachain’s Proof of Liquidity mechanism and Dolomite’s credit technology create additional synergy to improve borrowing, lending and trading within the ecosystem.
Finally, collateral can be used to vote, wager, or earn rewards, even if one borrows against it. The platform passes on the rewards to its users.
