Collateralization

Definition of collateralization

La collateralization is a financial mechanism where an asset is used as collateral to secure a loan or financial obligation. It allows borrowers to access financing by offering security to lenders, who can recover their capital in the event of non-payment. This process is essential in bank lending, financial markets, and DeFi, where the cryptoassets serve as collateral in automated protocols.

How collateralization works

When a borrower wants to obtain financing, he puts an asset as collateral, which can be real estate, shares, bonds or cryptoassets. In exchange, the lender grants a loan whose amount depends on the value of this asset, according to a ratio called Loan-to-Value (LTV). For example, if an asset is worth 100,000 euros and the LTV ratio is 70%, the borrower can get up to 70,000 euros. This mechanism protects the lender against market volatility and the risk of depreciation of the collateral asset.

Use in traditional finance and DeFi

In the traditional finance (TradFi), collateralization is commonly used for mortgages, where real estate is used as collateral. In financial markets, investors can use bonds or stocks as collateral to borrow cash. En DeFi, the cryptoassets are collateralized in protocols to obtain loans or generate passive returns. Unlike TradFi, these transactions are often managed by Smart Contracts, guaranteeing the automatic execution of defined rules without intermediaries.

Risk Management and Liquidation

A key part of the process is the risk management. If the collateral value falls below a critical threshold, a margin call may be triggered, requiring the borrower to add collateral or repay part of the loan. If there is no response, the asset may be liquidated to cover the debt. This protection is essential to maintain the stability of financial markets and to avoid excessive losses for lenders.

Benefits of collateralization

Collateralization reduces risks for lenders by offering them a tangible asset as collateral. For borrowers, it allows them to obtain larger loans and at better rates depending on the quality of the collateral. It also promotes the liquidity of assets by allowing them to be used as financial leverage.

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