Collateral Token

A collateral token is a crypto token used to secure a loan, a leveraged trade or another obligation. The term is used in two related ways. In the first, it means any token that a lending protocol or exchange accepts as collateral, such as ether, wrapped bitcoin or a stablecoin. In the second, it means a token that a protocol issues to a user as a receipt for collateral they have deposited, which tracks the deposit and can often itself be used elsewhere.

Both meanings come from decentralized finance (DeFi), where loans are typically overcollateralized and managed by smart contracts rather than by a lender's staff. Collateral tokens are central to lending markets such as Compound and Aave, to crypto-backed stablecoins such as Dai, and to derivatives platforms. How safe a system is depends heavily on which collateral tokens it accepts and on what terms.

When you borrow from a pawnshop, you leave something valuable behind, and the shop gives you a ticket. In DeFi, the valuable thing you leave is a token, such as ether, and that is a collateral token in the first sense. Many DeFi apps then hand you a digital ticket, itself a token, that proves you have something deposited.

That ticket is a collateral token in the second sense. Unlike a paper ticket, it can often be passed around, sold or even deposited somewhere else as security for another loan. This makes DeFi flexible, but it also means one deposit can end up supporting a chain of loans, so a problem with the original deposit can travel a long way.

Lending protocols decide through governance which tokens they will accept as collateral, and on what terms. Each accepted token is given a collateral factor or loan-to-value limit, and often a collateral cap. Common categories include:

• Major coins. Ether and bitcoin, the latter usually in the form of wrapped tokens on other chains.
• Stablecoins. Dollar-pegged tokens such as USDC and Dai, which have low price volatility.
• Liquid staking tokens. Tokens from liquid staking that represent staked ether and earn rewards.
• Governance and other tokens. Accepted with stricter limits because they are more volatile and less liquid.
• Tokenized real-world assets. Tokens backed by government bonds or other off-chain assets, increasingly accepted by some protocols.

When users deposit assets into a lending market, many protocols issue receipt tokens in return. Compound's original design issued cTokens, such as cETH, whose exchange rate against the underlying asset rises as interest accrues. Aave issues aTokens, whose balance grows in the holder's wallet. MakerDAO, by contrast, records collateral inside a vault, described under collateralized debt position, rather than issuing a transferable receipt. Receipt tokens make deposits composable: they can be traded, used as collateral elsewhere or added to liquidity pools, an example of composability. Redeeming them returns the original asset plus interest, provided the protocol has enough liquidity.

Collateral tokens carry several layers of risk. The price of the underlying token can fall quickly, triggering liquidations and possibly cascading liquidations. Thinly traded tokens can be manipulated, letting attackers inflate their value and borrow against it. Receipt and wrapped tokens add smart contract risk and depend on the solvency of the protocol or bridge behind them; if that protocol is hacked, the receipt can lose its value even when the original asset is unaffected. Using one receipt token as collateral for another loan, and so on, builds hidden leverage across the system. Liquid staking tokens can also trade below the value of the staked asset during stress, as happened briefly with staked ether in 2022.

Traditional secured lending uses collateral such as property, bonds or cash, held by custodians and valued with haircuts. DeFi collateral tokens play a similar role but are priced by blockchain oracles, liquidated automatically and available around the clock. Receipt tokens resemble collateral rehypothecation, where a lender reuses pledged collateral, though in DeFi it is the depositor who reuses it. Regulators studying DeFi have pointed to these similarities when assessing financial stability risks. A key difference is that DeFi liquidations happen automatically and without notice, whereas traditional lenders usually issue margin calls and give borrowers time to respond.