Crypto glossary

Overcollateralization

Overcollateralization means locking up collateral worth more than the loan or stablecoins issued against it, for example 150 dollars of ETH to borrow or mint 100 dollars of stablecoins. The extra value is a safety buffer against price drops.

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Why the buffer exists

Crypto collateral is volatile, and a smart contract cannot chase a borrower for missing money. If a loan were backed by exactly its own value, any small price drop would leave the lender with a loss. By demanding more collateral than the debt, the protocol has time to sell that collateral, through liquidation, while it still covers what is owed.

This model is used by DeFi lending protocols and by crypto-backed stablecoins such as DAI, where users lock assets in a vault and mint stablecoins against them.

An example

Say a stablecoin system requires a collateral ratio of at least 150 percent. You lock 3 ETH worth 3,000 dollars and mint 1,500 stablecoins, giving you a ratio of 200 percent. If ETH falls to 750 dollars, your collateral is worth 2,250 dollars and the ratio is exactly 150 percent. Any further drop makes the vault eligible for liquidation: the protocol sells your ETH to cover the 1,500 debt, and a penalty is deducted from what is left.

Trade-offs

Overcollateralization is safe for the system but capital-inefficient for the user: you must tie up more value than you receive. That is why people mostly use it to keep exposure to an asset they do not want to sell, or to take on leverage, rather than as a cheap source of money.

Uncollateralized or undercollateralized lending exists in crypto too, but it depends on trust in known borrowers, and several centralized lenders that lent this way failed in 2022.

Where it can fail

The buffer protects only against moves it was sized for. A sudden crash, a network so congested that liquidations cannot execute, or a faulty oracle price can leave debts uncovered. Using several correlated assets as collateral offers less protection than it seems, because they tend to fall together.

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Frequently asked questions

Why would anyone borrow less than they deposit?

To get spending money or leverage without selling an asset they want to keep, for example to avoid giving up a long-term ETH position.

What is a collateral ratio?

The value of the collateral divided by the value of the debt. A 200 percent ratio means 2 dollars of collateral for every 1 dollar borrowed.

Is DAI overcollateralized?

Yes. DAI is minted against collateral locked in smart contracts that must be worth more than the DAI issued.

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All glossary terms · Educational reference only — not investment, legal, tax or financial advice.