What is Collateral?

Plain-English explainer · Updated 2026-07-27 · By DeFi Intel

Collateral is the asset a borrower pledges to secure a loan. In traditional finance a bank can rely on credit scores and courts; a smart contract can rely only on what it holds. That is why DeFi lending is overcollateralized: the value you lock must exceed the value you borrow, so that even if you walk away, the protocol can sell your collateral and make depositors whole.

How it works

You start by supplying an asset — ETH, a liquid staking token, a stablecoin — to a lending protocol. Each collateral asset carries risk parameters set by governance: a loan-to-value (LTV) ratio that caps how much you can borrow against it, and a slightly higher liquidation threshold that marks the point where the position becomes unsafe. Riskier, more volatile assets get lower LTVs than deep, stable ones.

While the loan is open, a price oracle continuously revalues the collateral. The gap between the LTV cap and the liquidation threshold is the borrower's safety buffer: if prices drop and the debt crosses the threshold — on Aave, when the health factor falls below 1 — liquidators can repay part of the loan and take collateral at a discount. Interest accrues on the debt the whole time, so a position can drift toward liquidation even in a flat market.

Collateral also backs assets beyond loans. Collateralized debt positions mint stablecoins against locked assets — Sky (formerly MakerDAO) issues DAI/USDS against collateral vaults — and derivatives protocols hold margin collateral against open positions. In every case the logic is the same: locked value stands behind an obligation, and the protocol seizes it if the obligation is not met.

Why it matters

Overcollateralization is what makes permissionless credit possible: no identity, no credit history, just verifiable locked value. It is also DeFi's core constraint — capital efficiency is limited, and cascading collateral liquidations amplify market crashes.

Real-world examples

On Aave you can supply ETH as collateral and borrow stablecoins against it up to the asset's LTV cap. Sky (MakerDAO) mints its stablecoin against overcollateralized vaults, and Compound and Morpho run the same supply-borrow-liquidate model with their own risk parameters.

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