Here's the thing about DeFi that confuses traditional finance people: if you want to borrow $10,000, you need to deposit $15,000-20,000 worth of crypto as collateral. So you're locking up more money than you're borrowing, which seems completely backwards until you realize it's the entire reason DeFi lending can exist without credit checks, KYC, or trusting strangers.

Collateral in crypto is an asset you deposit into a DeFi protocol to secure a loan. The key difference from traditional finance is overcollateralization—you must deposit more value than you're borrowing, typically 130-200% of the loan amount. This seems inefficient, but it's what makes permissionless lending possible. The protocol doesn't know anything about you because the math guarantees it can't lose money: if you don't repay, it keeps your collateral which is worth more than the loan.

Why DeFi requires overcollateralization

Traditional finance does undercollateralized lending constantly. Your mortgage requires maybe 20% down. Credit cards are completely uncollateralized—banks lend based on credit scores. This works because banks verify your identity, check your credit history, and can legally pursue you if you default.

DeFi has none of these tools. No KYC, no identity verification, no credit checks, no legal recourse. So instead of trusting you'll repay, DeFi protocols trust math: if your collateral is worth more than your debt, they can't lose money even if you never repay.

Overcollateralization is the price of permissionlessness. Anyone can borrow, but they must prove solvency upfront. For users in countries with restricted access to traditional credit, this trade-off is worth it. The other benefit is instant liquidations—automated bot-driven seizure of collateral protects lenders from market volatility far better than months-long foreclosure processes.

How collateral works in DeFi

Let's walk through a real example using Aave. You deposit $15,000 worth of ETH as collateral to borrow $10,000 USDC (150% ratio). Aave locks your ETH and gives you the USDC.

Your position has a "health factor" calculated from collateral value versus debt. Above 1.0 you're safe, below 1.0 you get liquidated. With $15k collateral and $10k debt, your health factor is around 1.5.

If ETH's price drops 20%, your collateral is worth $12,000. Health factor dropped to 1.2—getting close to danger. Another 20% drop puts you at $9,600 collateral versus $10,000 debt. Health factor below 1.0. LIQUIDATION.

Liquidator bots constantly monitor positions. The instant your health factor drops below 1.0, they pay off part of your debt and seize your collateral at a 5-10% discount. You just lost your ETH, paid penalties, and might still owe remaining debt.

Different collateral types and risk levels

Not all collateral is treated equally. Protocols assign different loan-to-value (LTV) ratios based on asset risk:

ETH gets 75-82.5% LTV on Aave. You can borrow up to $75-82.50 per $100 deposited. It's liquid, relatively stable for crypto, and widely accepted—premium collateral.

Stablecoins like USDC get 80-90% LTV. They're the safest collateral since prices don't fluctuate much.

Major altcoins like LINK, AAVE, UNI get 60-75% LTV. More volatile, less liquid—protocols require more overcollateralization.

Risky/small-cap tokens get 30-50% LTV or aren't accepted at all. They could crash 50% overnight.

Real-world assets like tokenized treasuries are emerging as collateral, blurring lines between DeFi and traditional finance.

The LTV determines leverage and risk. Higher LTV means less overcollateralization needed but closer to liquidation. Conservative borrowers use 40-50% of max LTV. Degens push 80-90% and get liquidated when markets hiccup.

Liquidation mechanics

During major crashes, liquidation cascades occur. Thousands of positions hit thresholds simultaneously. Liquidators flood the network, gas fees spike to $500+ as bots compete. Some positions can't get liquidated fast enough due to congestion. If collateral crashes faster than liquidations execute, protocols end up with bad debt.

The May 2021 crash saw over $1 billion liquidated in 24 hours. March 2020's "Black Thursday" was worse—ETH dropped 30% in hours, network congestion prevented timely liquidations, and MakerDAO ended up with millions in undercollateralized debt. These stress tests led to protocol improvements: better oracle systems, faster liquidations, higher collateralization requirements.

Managing collateral to avoid liquidation

Maintain healthy buffer: Don't borrow maximum allowed. If you can borrow 75% LTV, only use 40-50%. This gives cushion for volatility.

Monitor health factor: Check positions daily during volatility. Set alerts when it drops below 1.5. Don't let it approach 1.0.

Add more collateral or repay debt: If health factor drops, deposit more collateral or repay part of the loan. This requires having reserves available. Many degens get liquidated because they deployed 100% of capital.

Use stablecoin debt: Borrowing stablecoins against volatile collateral means only your collateral price matters, removing one variable.

Conservative borrowers manage collateral actively and rarely get liquidated. Degen farmers max out leverage for yields and learn expensive lessons when markets crash while they're sleeping.

Cross-collateralization and isolated markets

Some protocols offer cross-collateralization where your entire portfolio backs all borrowing. This is capital efficient but creates contagion risk: if one asset crashes, it affects all positions.

Isolated markets segment collateral by pool. If one asset crashes, only that isolated position gets liquidated. Aave V3 introduced isolation mode for risky assets, preventing them from contaminating the protocol.

The honest take

Overcollateralization is simultaneously DeFi's biggest limitation and strength. It's capital inefficient—you can't borrow more than you deposit. But it's also why DeFi lending works without intermediaries. No KYC, no credit checks, no trusting strangers—just math ensuring the protocol can't lose money.

The real innovation isn't overcollateralization itself (pawnshops have existed forever)—it's automated, algorithmic management at scale. Billions in collateral managed by smart contracts, liquidations triggering instantly based on oracle prices, interest rates adjusting automatically. Traditional finance couldn't operate this way profitably at small scale, but DeFi's zero-marginal-cost smart contracts make it viable.

For users, the system is straightforward once you understand the mechanics. Don't over-lever. Monitor your positions. Maintain healthy buffers. Follow these rules and you'll rarely get liquidated.

Crypto collateral is the foundation enabling trustless finance. Imperfect, capital inefficient, but functional at scale. Until someone figures out undercollateralized DeFi lending that doesn't immediately get exploited (spoiler: they keep trying, it keeps failing), overcollateralized lending will remain the core of DeFi credit markets.

Further Reading:

• Aave Collateral Guide - How collateral works on Aave
• Compound Collateral Mechanics - Collateral factors and borrowing
• MakerDAO Vaults - Collateralized DAI creation
• Liquidation Mechanics Explained - How liquidations protect protocols
• LTV Ratios by Asset - Risk parameters for different collateral
• DeFi Llama - Liquidation Tracker - Real-time liquidation data
• Loan-to-Value Explained - Understanding LTV in DeFi
• Collateral Risk Management - Isolation mode for risky assets
• Black Thursday Analysis - Case study of liquidation failures
• RWA Collateral - MakerDAO - Real-world assets as crypto collateral