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.