What Is the Role of Collateralization in Reducing Counterparty Risk in DeFi?

Collateralization in DeFi is the practice of a borrower pledging assets as security for a loan or financial position. This is fundamental to reducing counterparty risk in a trustless environment.

By locking collateral into a smart contract, lenders are assured that there are assets available to cover the loan in the event of a default. The smart contract acts as a neutral escrow, automatically managing the collateral based on predefined rules.

This system replaces the need for credit checks and legal agreements, relying instead on economic guarantees.