Overcollateralizing

Overcollateralizing is a practice common in various financial contexts, particularly in decentralized finance (DeFi) and traditional lending. It refers to the act of providing collateral that has a value significantly higher than the loan amount being sought. This excess collateral serves as a buffer to protect the lender against potential losses.

In DeFi, overcollateralization is a fundamental mechanism for enabling lending and borrowing without traditional credit checks or intermediaries. When a user deposits cryptocurrency as collateral to borrow another asset, the value of the deposited collateral typically exceeds the value of the borrowed asset by a predetermined percentage. This ensures that even if the price of the collateral drops, it still covers the value of the loan. If the collateral's value falls below a certain threshold, it can be liquidated to repay the loan, protecting the lending protocol.

In traditional finance, overcollateralization might be required for loans involving assets with volatile market values or for borrowers with lower creditworthiness. For instance, a lender might ask for collateral worth 150% of the loan amount to mitigate the risk associated with potential price fluctuations or the borrower's inability to repay. The specific overcollateralization ratio varies depending on the asset class, market conditions, and the risk appetite of the lender. The primary goal remains the same: to minimize the lender's exposure to risk.