How Do Decentralized Finance (DeFi) Protocols Use Over-Collateralization to Manage Risk in Derivatives?
Over-collateralization is a primary risk management tool in DeFi. To take out a loan or open a derivatives position, a user must deposit collateral that is worth significantly more than the value of the position itself.
For example, to borrow $100 of a stablecoin, a user might need to deposit $150 worth of a volatile cryptocurrency. This excess collateral acts as a buffer.
If the value of the collateral drops, the system can liquidate it to cover the debt well before it becomes undercollateralized, thus protecting the protocol and its lenders from losses even in a volatile market.
Glossar
Capital Efficiency
Leverage ⎊ Capital efficiency, within cryptocurrency and derivatives, fundamentally represents the maximization of risk-adjusted returns relative to capital at risk, a metric increasingly vital given regulatory constraints and market volatility.
Decentralized Finance (DeFi)
Architecture ⎊ Decentralized Finance (DeFi) fundamentally reconfigures traditional financial infrastructure by leveraging blockchain technology, primarily Ethereum, to create open, permissionless, and transparent systems.
Excess Collateral
Buffer ⎊ Excess collateral is the value of deposited digital assets that surpasses the minimum collateralization requirement mandated by a decentralized lending platform or derivatives exchange.
Decentralized Finance
Architecture ⎊ Decentralized Finance, or DeFi, fundamentally reimagines traditional financial infrastructure through blockchain technology, specifically leveraging smart contracts to automate and execute financial agreements without intermediaries.