Collateral, and particularly over-collateralization, is a basic mechanism essential to safe all lending and borrowing actions within the decentralized monetary sector.
Collateralization is crucial to DeFi and the essential idea is easy sufficient. By placing up extra capital than you propose to borrow, the method protects lenders in opposition to the chance of the borrower defaulting. The one profit to debtors has been that collateral offers them entry to loans within the first place, however newer protocols like Dolomite are rising that may lengthen the advantages of overcollateralization to each events.
What’s overcollateralization?
Within the DeFi ecosystem, protocols can’t leverage conventional credit score scoring techniques resulting from its decentralized nature, which basically means customers are nameless. So, to facilitate entry to loans, customers should deposit collateral, within the type of cryptocurrency tokens.
DeFi lending is subsequently structured as over-collateralized schemes, the place the borrower deposits crypto belongings which have a higher worth than the quantity they plan to borrow. It’s a crucial apply because of the excessive volatility of crypto, the place asset costs can fluctuate considerably in a really quick time frame. The method of overcollateralization creates a buffer that gives safety to liquidity suppliers and different lenders within the occasion that the worth of the collateral falls sharply.
Collateralization is crucial to DeFi and the essential idea is easy sufficient. By placing up extra capital than you propose to borrow, the method protects lenders in opposition to the chance of the borrower defaulting. The one profit to debtors has been that collateral offers them entry to loans within the first place, however newer protocols are rising that may lengthen the advantages of over-collateralization to each events.
In most DeFi protocols, these safeguards lengthen to liquidation. If the worth of the collateral falls under a minimal threshold, the mortgage is liquidated, which implies that the collateral is bought and customers should repay the lenders except the borrower is prepared to deposit extra to make sure that their whole deposit meets the minimal necessities meets.
In fact, the overcollateralization mannequin is much from splendid, because it clearly excludes those that may have financing greater than anybody else – those that do not have the collateral to start with. However, it’s important for many lenders, particularly conventional establishments, which should function in techniques with strong threat mitigation frameworks. The collateral cushion gives peace of thoughts that loans are at all times absolutely coated, even when the underlying asset is delicate to fast and unpredictable value adjustments.
How does overcollateralization work?
DeFi lending advantages from much more ensures when stablecoins are used as main collateral. Stablecoins pegged to conventional belongings such because the US greenback, the euro and even conventional commodities corresponding to gold are a lot much less risky than different kinds of crypto belongings. As such, stablecoins are a way more steady type of collateral, additional lowering the chance related to the worth of the collateral.
Utilizing stablecoins as collateral additionally protects debtors, who face important dangers if the worth of their collateral falls sharply they usually can now not deposit to cowl the shortfall.
Furthermore, over-collateralization can be the method by which stablecoins are minted.
An instance of that is the DAI stablecoin, which is pegged to the US greenback and operates a lending and reimbursement course of that leverages an over-collateralized debt place by means of MakerDAO, which secures digital belongings as collateral on-chain. MakerDAO permits customers to deposit Ether or plenty of different accepted tokens and borrow in opposition to the worth of these belongings to mint new DAI tokens.
Different stablecoins, corresponding to USDT and USDC, are backed by fiat collateral from their backers, the businesses Tether Ltd. Inc. and Circle Web Monetary Ltd.
Selling over-collateralization
The basic means of over-collateralization is easy sufficient to know, however it could possibly result in many complications for DeFi lenders once they attempt to interact in complicated yield farming actions. For instance, DeFi customers typically borrow cash from protocols to permit them to maximise their staking rewards on proof-of-stake tokens, or pay down different debt.
The problem is that the DeFi protocols don’t present any seamless course of for this, and customers are compelled to do the whole lot manually, which makes all the course of overly difficult, rising the chance of liquidation for the borrower.
Happily, some protocols are working to streamline these processes in order that debtors can maximize the capital effectivity of their collateral. For instance, Dolomite permits customers to benefit from a course of considerably just like remortgage, the place borrowed belongings will be recollateralized as a down fee for extra loans.
For instance, somebody might go to Dolomite and deposit yield-bearing jUSDC tokens as collateral for a USDC mortgage. If the consumer deposits 100 jUSDC, he can borrow 70 USDC after which use that USDC to purchase extra jUSDC. As such, they are going to be left with 170 jUSDC, rising the APR they’ll earn on their jUSDC holdings.
That extra jUSDC can then be added to the unique borrowing place, leaving them with 170 jUSDC. It’s attainable to repeat this course of plenty of instances to maximise capital effectivity and earn as much as 70% APY, and because of Dolomite’s new Zap function, which automates complicated transactions, this whole course of will be accomplished simply as soon as, in as an alternative of the consumer regularly withdrawing funds, shopping for extra jUSDC, depositing and doing it once more.
The same course of can be utilized to not improve the APY, however as an alternative acquire extra voting rights by accumulating extra governance tokens, corresponding to by means of the voting vARB token, which is a spinoff of Arbitrum’s native ARB token .
vARB permits customers to uniquely borrow in opposition to their ARB deposits whereas taking part in board voting on the Arbitrum community. Whereas ARB will be lent, borrowed, and used as collateral, it can’t be used to vote as it’s locked into protocols, whereas vARB tokens can be utilized to vote on governance.
A consumer can go to Dolomite and convert 100 ARB tokens into vARB, which may then be used as collateral to borrow 400 ARB through the Zap function. After borrowing 400 ARB, this will then be transformed to 400 vARB, with a debt of 400 ARB. Collateral will develop on the identical charge because the borrower’s debt, eliminating the chance of liquidation resulting from asset value volatility.
Dolomite’s platform is subsequently rather more versatile than different protocols, corresponding to Rodeo Finance, which permit the leverage of belongings corresponding to jUSDC, GLP and plvGLP, however with little flexibility. With Dolomite, customers acquire extra management over leverage and the belongings used as collateral, and don’t lose any of the rewards these belongings generate as a result of the whole lot is handed to the consumer.
Dolomite additionally stands out in the way in which it permits customers to benefit from the performance of their belongings even when they’re posted as collateral. So somebody who deposits jUSDC to borrow USDC can nonetheless use their jUSDC to vote, wager, or earn different kinds of rewards. Worth is additional enhanced by Dolomite’s new ‘rinse and repeat’ capabilities, permitting debtors to cycle by means of a number of cycles to maximise capital effectivity whereas minimizing any liquidation threat.