Overcollateralization is a key mechanism underlying borrowing and lending in DeFi. Debtors put up collateral to entry loans, that are arrange as overcollateralized schemes. Which means the asset worth deposited by a borrower should be larger than the mortgage quantity he receives.
This observe protects merchants from the usually excessive worth swings that characterize cryptocurrency markets. Over-collateralized positions permit debtors to construct a cushion that protects liquidity suppliers and lenders in case the worth of the collateral immediately plummets.
Learn how to construct an overcollateralized place on a buying and selling platform
As an example somebody is anxious about inflation hitting the US greenback. They will deposit a cryptocurrency of their selection, borrow US {dollars}, change the USD for that crypto and deposit it again into the lending dApp. On this method, they take a bearish place on the greenback whereas rising their publicity to crypto belongings.
If their prediction comes true and an inflation spike happens, the value of the crypto asset ought to improve by not less than the inflation quantity, whereas the US greenback quantity stays fixed. The dealer can use the income on the borrowed crypto to repay the mortgage in US {dollars} and nonetheless maintain the crypto and the income from the unique crypto deposit.
Let us take a look at a sensible instance. After selecting a platform that enables over-collateralization, a dealer can deposit ether price $1,500 and borrow USDC for $500, which equates to a 300% collateral ratio. If the value of ether falls considerably, there’s a 150% buffer earlier than the liquidation threshold is reached.
Platforms usually settle for ether, Bitcoin or stablecoins. Stablecoins are much less risky than different cryptocurrencies, which is without doubt one of the causes they’re engaging to institutional lenders. As well as, their worth is simpler to foretell, making them extra appropriate for lending as this reduces the danger related to assessing the worth of collateral.
Platforms like Dolomite provide instruments which have turn into an integral a part of trendy lending programs. A few of these devices constantly assess the liquidity of collateral belongings, permitting lenders to observe collateral values and market situations in actual time.
In DeFi lending, the over-collateralization ratios function essential metrics that decide the worth of the collateral required in opposition to the mortgage quantity. They’re all the time above 100% to guard the dealer from market volatility. Every platform determines these ratios based mostly on historic volatility knowledge, market situations and the perceived threat of the collateral sort. If the platform establishes a collateral ratio of 150%, the dealer should present an asset price not less than 150% of the mortgage quantity. They will then exceed the minimal ratio that requires overcollateralization by offering collateral price 200% or extra of the mortgage quantity.
Absolutely automated lending will quickly turn into a actuality
The method of borrowing belongings will turn into totally automated within the close to future with Dolomite’s new “Zap” characteristic. Growing leverage on an asset by borrowing in opposition to it after which shopping for it’s fairly annoying. Posting collateral, borrowing in opposition to it, withdrawing from the platform, getting extra collateral and depositing it, borrowing once more, and so forth till the specified leverage is achieved will all be lowered to a single step. Zap will even make it doable to make use of collateral to repay debt able as an alternative of unwinding a borrowing place by reversing the loop course of. Zap will use a DEX aggregator to execute these trades, and customers is not going to expertise any liquidity points.
Margin merchants ought to open a leveraged place. The quantity they’ll borrow will depend on the platform’s loan-to-value ratio. A ratio of 45% signifies that they’ll borrow as much as 45% of the collateral deposited. If the worth of the borrowed asset will increase or the worth of the collateral decreases, the place may be liquidated. To keep away from this, merchants ought to examine the ratio recurrently. The dealer repays the mortgage plus any charges or curiosity to shut the place. They withdraw their collateral as soon as the mortgage is repaid.
The dangerous and the ugly
As an example a dealer places up $20,000 price of ether as collateral to borrow USDT price $1,000. It is a basic instance of inefficient over-collateralization, the place the 2000% ratio is considerably larger than the everyday requirement of 150-200%. The dealer holds a considerable amount of capital with out using it successfully.
Utilizing a borrowed asset as collateral is even riskier and fewer environment friendly. It appears counterintuitive, however a dealer can borrow an altcoin price $5,000 in opposition to ether price $10,000. They re-deposit the altcoin as collateral to borrow extra ether. Using a borrowed asset to safe additional credit score threat. If the worth of the borrowed asset declines, it will result in multi-tiered liquidation.
Borrowing, re-depositing and re-borrowing comes with excessive charges and rates of interest, consuming into any income. The person is in the end uncovered to each the volatility of the collateral and the efficiency of the borrowed asset, doubling the danger. A drop within the worth of collateral or borrowed belongings may wipe out all of the seed capital in a downright ugly situation.
Alternatives that transcend lending and borrowing
Dolomite solely permits margin and spot buying and selling of ETH-USDC, however as soon as it integrates the aggregator, customers will be capable to commerce just about any asset with exterior liquidity, eliminating the danger of slippage and restricted markets. It provides margin buying and selling on belongings not obtainable elsewhere.
Customers can deposit ether and USDC and earn curiosity on loans, then add these belongings to a liquidity pool and earn buying and selling charges. They will generate profits by lending the USDC-ETH liquidity pool token. Moreover, with the combination of Dolomite into Berachain via the Royco Pre-Deposit Marketing campaign, customers may have much more alternatives to maximise capital effectivity. Berachain’s Proof of Liquidity mechanism and Dolomite’s credit score know-how create further synergy to enhance borrowing, lending and buying and selling throughout the ecosystem.
Lastly, collateral can be utilized to vote, wager, or earn rewards, even when one borrows in opposition to it. The platform passes on the rewards to its customers.