Collateralization

Collateralization is the practice of securing a loan or other financial obligation with an asset, called collateral, that the lender can take and sell if the borrower fails to pay. A home serves as collateral for a mortgage, a car for a car loan, and bonds or cash for many trades between banks. Collateralization reduces the lender's risk, which usually lets the borrower obtain a larger loan or a lower interest rate than they would get on an unsecured basis.

The term also describes the degree to which an obligation is covered by collateral. A loan is overcollateralized when the collateral is worth more than the debt, fully collateralized when the two are equal and undercollateralized when the collateral falls short. These ideas are central to bank lending, securities financing, securitization and, in crypto, to decentralized finance and stablecoins.

If a friend asks to borrow money, you might ask them to leave their bicycle with you until they pay it back. If they do, you return the bike; if they do not, you keep it and sell it to recover your money. That is collateralization: something of value stands behind the promise to repay.

The more the bicycle is worth compared with the loan, the safer you feel. If you lent 100 against a bike worth 150, you have a cushion even if bike prices fall a little. If you lent 100 against a bike worth 80, you are already exposed. Lenders, banks and crypto apps all think in exactly these terms, just with homes, bonds and tokens instead of bicycles.

The degree of collateralization is usually expressed as a ratio:

For example, a borrower who deposits ether worth $15,000 to borrow $10,000 of a stablecoin has a collateralization ratio of 15,000 ÷ 10,000 × 100% = 150%. If ether falls by 20%, the collateral is worth $12,000 and the ratio drops to 120%. Lenders set a minimum ratio, below which they can demand more collateral or sell it. The same idea is often expressed the other way round as the loan-to-value ratio; a 150% collateralization ratio equals a loan-to-value ratio of about 67%.

Collateral is used across the financial system:

• Secured loans. Mortgages, car loans and asset-based lending to companies are backed by property, vehicles, inventory or receivables.
• Repo and securities lending. Banks borrow cash against government bonds, with a haircut applied to the bonds' value.
• Derivatives. Counterparties post initial and variation margin, and central clearing houses require collateral from members.
• Structured products. Pools of loans back securities such as collateralized mortgage obligations, with some deals overcollateralized to protect senior investors.

Central banks also lend only against eligible collateral, which makes the quality and supply of collateral an important part of how money markets work.

Because DeFi borrowers are often anonymous and cannot be sued, crypto lending relies almost entirely on overcollateralization. Lending protocols set a collateral factor for each asset and liquidate positions automatically when ratios fall too low. Crypto-backed stablecoins such as Dai require vaults to be overcollateralized, often at 150% or more, to absorb price swings, as explained under collateralized stablecoin. Fiat-backed stablecoins aim to be fully collateralized by cash and short-term government debt. Undercollateralized crypto lending exists, mainly to institutions, but the failures of several such lenders in 2022 showed its risks.

Collateral protects lenders only if it can be valued correctly and sold quickly. In a crisis, many lenders may try to sell the same kind of collateral at once, driving down prices and causing further margin calls, a dynamic seen in the 2008 financial crisis and in crypto sell-offs. Collateral can also be pledged more than once, as in collateral rehypothecation, creating chains of claims. Heavy reliance on collateral can exclude borrowers who lack assets, which is one reason overcollateralization limits the usefulness of DeFi for everyday credit. Lenders also face legal risk: in some jurisdictions, seizing and selling collateral can take months or years through the courts, and the value recovered after costs may be far below the value recorded when the loan was made. For that reason, banks combine collateral with assessments of the borrower's income and credit history rather than relying on collateral alone.