What is over-collateralisation?
- Author
- CRYPTO PORT Editorial
- Published
- Updated
- Reading time
- 4 min
In short
Over-collateralisation means locking up more value than you borrow. Because a DeFi lender knows nothing about the borrower, it needs a buffer large enough to survive a fall in collateral value, so this is the default design. It is capital-inefficient by construction, and that inefficiency is what protects lenders from bad debt.
Key points
- You pledge more value than you receive
- The excess absorbs price moves and liquidation delays
- Volatile collateral requires a larger buffer
- It sacrifices capital efficiency to limit bad debt
Definition
A requirement that pledged collateral be worth more than the loan, so that the lender can still recover the debt after the collateral has fallen in value.
If a protocol caps borrowing at some fraction of the value of ETH collateral, pledging ETH worth ¥100,000 gets you less than that in loan. The difference is the cushion that keeps the debt recoverable after a fall. How large it needs to be depends on how violently the asset moves and how easily it can be sold.
The cushion also has to cover liquidations that do not complete promptly. Sharp sell-offs congest the network, so liquidation transactions can sit unconfirmed while the price keeps falling. With a thin buffer, selling all the collateral may still not cover the debt — protocols have been left with bad debt after exactly this sequence.
Because the design is over-collateralised, you can never borrow more than you posted. It suits keeping exposure to ETH while raising cash, or borrowing against holdings you do not want to sell; it does not create unlimited leverage. Using the borrowed funds to buy more collateral does raise effective leverage, and it narrows the distance to liquidation very quickly.
Watch out for
- · Even a generous buffer can fail if congestion delays liquidations during a crash, leaving the protocol with bad debt
- · Collateral factors are governance parameters and can be tightened, affecting positions that are already open
- · Recycling borrowed funds into more collateral is leverage, and small drops then reach the liquidation threshold