Understanding Collateralized Loans on DeFi Platforms
In decentralized finance, collateralized loans let users borrow against assets they lock in a smart contract. Instead of a traditional bank, a protocol’s code governs loan terms, repayment, and liquidation. The idea is simple: your collateral provides security for the loan, and the protocol ensures that lenders are protected through automatic rules written into the contract.
How collateralized loans work
A typical DeFi loan follows a clear path, driven by on-chain data and transparent conditions.
- Deposit collateral (for example, ETH, BTC, or a stablecoin) into the lending pool.
- Borrow a loan token up to a designed loan-to-value (LTV) ratio.
- Monitor the position so you maintain enough collateral relative to the outstanding loan.
- If prices move unfavorably, the system can liquidate a portion of the collateral to cover the loan, or prompt you to add more collateral.
- Repay the loan and reclaim your collateral once the balance is settled.
Key terms to know
- Loan-to-Value (LTV) — the borrowable amount as a percentage of collateral value.
- Liquidation threshold — the market price at which liquidation can be triggered.
- Collateralization ratio — the ratio of collateral value to loan amount; higher ratios reduce risk but cap borrowing.
- Oracles and price feeds — external data sources that keep price information current in smart contracts.
“Many DeFi borrowers favor over-collateralization because it reduces the need for trusted intermediaries, but it also means you must actively manage price risk.”
Benefits, trade-offs, and risks
- Access liquidity without selling key assets, enabling portfolio rebalancing or capital for opportunities.
- Transparent, programmable terms with automated risk controls.
- Risks include price volatility, sudden liquidations in fast-moving markets, smart contract bugs, and platform-specific fees.
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Practical considerations when choosing a platform include assessing supported collateral types, the stability of price feeds, the speed of liquidations, and any gas or platform fees. Start with a small, test position to understand how the protocol behaves during a volatile moment, and keep an eye on your margin levels as market conditions change.
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