Collateral Factor

A collateral factor is the maximum percentage of an asset's value that a borrower can borrow against it in a lending protocol. If an asset has a collateral factor of 75%, depositing $1,000 of it lets the user borrow up to $750 of other assets. The term was popularised by Compound, one of the first decentralized finance (DeFi) lending protocols, and is set separately for each asset that the protocol accepts as collateral.

The collateral factor plays the same role as the loan-to-value ratio in a mortgage or the collateral haircut in repo lending: it keeps a cushion between the value of the collateral and the debt. Other protocols use different names. Aave, for example, distinguishes a maximum loan-to-value ratio for new borrowing from a higher liquidation threshold at which loans can be closed. In all cases the aim is to make sure loans can be repaid by selling the collateral if its price falls.

Picture a pawnshop. You bring in a watch worth 1,000 and the shop lends you 600 against it. The shop keeps 400 of breathing room because watch prices move around, and if it ever had to sell your watch in a hurry, it might not get the full price. The 60% is, in effect, the shop's collateral factor for watches.

A DeFi lending app does the same thing automatically, for every coin it accepts. Steadier coins, such as dollar stablecoins, get generous factors, perhaps 80% or more. Jumpy or little-traded coins get low factors, or none at all. If your coin's price drops so far that your loan no longer fits inside the limit, the app sells some of it to repay the loan.

A borrower's total borrowing capacity is the sum of each deposited asset's value multiplied by its collateral factor:

• $V_i$ is the current market value of deposited asset $i$, taken from the protocol's price feed.
• $CF_i$ is the collateral factor of asset $i$, written as a decimal.

For example, a user deposits ether worth $10,000 with a collateral factor of 0.80 and a governance token worth $2,000 with a factor of 0.50. Their capacity is 10,000 × 0.80 + 2,000 × 0.50 = $8,000 + $1,000 = $9,000. If they borrow $7,200 of a stablecoin, they are using 80% of their capacity. If ether falls by 15% to $8,500, the capacity drops to 8,500 × 0.80 + 1,000 = $7,800, still above the debt. A fall to about $7,750 would bring capacity down to $7,200, after which the position can be liquidated.

Protocols usually set collateral factors through governance votes by holders of a governance token, often on the advice of specialist risk firms. Factors considered include:

• Volatility. Assets that swing sharply in price get lower factors.
• Liquidity. Assets that are hard to sell in size without moving the price get lower factors, since liquidators must be able to sell collateral quickly.
• Oracle quality. Assets whose prices are hard to report reliably through a blockchain oracle are riskier.
• Concentration. Factors may be combined with a collateral cap to limit total exposure to one asset.

Changes are usually made gradually, because cutting a factor sharply can push existing borrowers into liquidation.

When the value of a user's debt exceeds their borrowing capacity, outside liquidators can repay part of the debt and take collateral at a discount, a process described under forced liquidation. Higher collateral factors improve capital efficiency for borrowers, but leave less room for error. If a factor is set too high, a sharp price fall or oracle failure can leave the protocol with bad debt, where collateral is worth less than the loans. In several DeFi incidents, attackers manipulated the price of a low-liquidity token, used its collateral factor to borrow more valuable assets and walked away, leaving the protocol with losses. Widespread liquidations can also feed cascading liquidations across markets.

In Compound's original design, each market had a single collateral factor set by governance, and users holding the COMP token could vote to change it. Later versions separated borrowing and liquidation limits, an approach now common across DeFi lending. The broader topic is covered under decentralized lending protocol.