Collateralized Lending & Borrowing

HODL While Accessing More Liquidity

Overview

Collateralized lending enables lenders to access additional liquidity generated from utilizing what would otherwise have been dormant assets. Prior to the creation of collateralized lending protocols, token holders who were bullish on a particular token could only realize capital gains by holding the token in their wallet. Collateralized lending enabled lenders to access more liquidity while offsetting the opportunity costs of HODLing their favourite tokens.

As users are able to specify their preferred collateral ratios, collateralized lending enables a user's liquidity to be leveraged accordingly. For example, a 50% collateralization ratio for a USD1,000 loan would enable the user to borrow an additional USD500 in liquidity. This results in the user getting access to 1.5x their initial liquidity (i.e. leverage ratio) which can then be utilized for other purposes such as purchasing more of the collateral asset or other trading strategies.

Collateralized loans can be forcefully closed (i.e. liquidated) if the value of the debt outweighs the collateral value after accounting for the collateralization ratio. Consequently, by opening a leveraged position, a user amplifies both their potential profits and losses as minor market movements are also scaled accordingly.

How Does It Work

Collateralized lending protocols enable the borrowing and lending of crypto assets. Crypto providers are able to earn an interest by depositing crypto to a specific pool (i.e. lending asset/debt asset) whereas borrowers are able to take out loans by collateralising crypto (i.e. borrow asset/collateral asset) and paying an interest. By allowing collateralization and lending across various cryptos, users are able to mix-and-match their current and borrowed assets according to their liquidity preferences.

A lending contract defines the asset to hold in reserve as well as the share of each borrower/lender. The interests paid to lenders or paid by borrowers is dynamically determined based on a combination of market mechanisms and protocol governance targets. Utilisation and collateralisation ratios can then be used to improve capital efficiency.

To ensure the solvency of the lending markets, most protocols also introduce a liquidation market. As on-chain actions require a gas fee to be paid, liquidators are incentivized to find and force close undercollateralized positions. A position becomes undercollateralized when the value of their borrowed asset (i.e. debt asset) is greater than the collaterlization ratio multiplied by their lending asset (i.e. collateral asset).