What Mechanisms Do Smart Contracts Use to Manage Collateral and Prevent Defaults in Lending?

Smart contracts in lending protocols use overcollateralization as the primary mechanism to prevent defaults. Borrowers must deposit assets of a value significantly higher than the value of the loan they wish to take.

The smart contract continuously monitors the value of the collateral relative to the loan value, a ratio known as the health factor. If the collateral's value drops below a predetermined threshold due to market volatility, the smart contract automatically triggers a liquidation process, selling the collateral to repay the loan and prevent losses for the protocol.