Collateralized vs. Overcollateralized vs. Undercollateralized DeFi Loans

Collateralized vs. Overcollateralized vs. Undercollateralized DeFi Loans

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In decentralized finance (DeFi), collateralized loans are loans secured by collateral, which the borrower must deposit to the lender as a guarantee for the loan. The collateral is typically cryptocurrency and held in a blockchain smart contract.

Overcollateralized loans are loans where the value of the collateral is greater than the loan’s value. This means that the lender has a cushion of additional collateral to protect against potential losses in case the value of the collateral drops.

On the other hand, undercollateralized loans are loans where the value of the collateral is less than the value of the loan. This means that the borrower is taking on more risk, as there is less collateral to protect against potential losses in case the value of the collateral drops.

The main difference between these types of loans is the level of risk for the lender and the borrower. Collateralized loans are generally considered the safest, as the lender has a guarantee in the form of collateral. Overcollateralized loans are also considered relatively safe, as the lender has a cushion of additional collateral to protect against potential losses. On the other hand, undercollateralized loans are considered riskier, as the lender has less protection in case the value of the collateral drops.

Similarities between the three types of loans are that all are secured by collateral, and all are used in DeFi lending platforms.

Practical Examples

Here is a practical example for each type of loan:

  • Collateralized loan: Alice wants to borrow $10,000 from Bob for 6 months. Bob agrees to the loan, but only if Alice provides $15,000 worth of Ethereum as collateral. Alice agrees and sends the Ethereum to a smart contract on the blockchain. Bob then sends $10,000 to Alice’s Ethereum wallet. The loan is now active, and the smart contract will hold the $15,000 worth of Ethereum as collateral until the loan is paid off or defaulted. After six months, Alice pays back the $10,000 plus interest to Bob, and Bob releases the Ethereum back to Alice.
  • Overcollateralized loan: Charlie wants to borrow $5,000 from Dave for 12 months. Dave agrees to the loan, but only if Charlie provides $10,000 worth of Bitcoin as collateral. Charlie agrees and sends the Bitcoin to a smart contract on the blockchain. Dave then sends $5,000 to Charlie’s Bitcoin wallet. The loan is now active, and the smart contract will hold the $10,000 worth of Bitcoin as collateral until the loan is paid off or defaulted. This is an overcollateralized loan, as the value of the collateral is greater than the loan’s value. After 12 months, Charlie pays Dave the $5,000 plus interest, and Dave releases the Bitcoin back to Charlie.
  • Undercollateralized loan: Eve wants to borrow $20,000 from Frank for three months. Frank agrees to the loan, but only if Eve provides $15,000 worth of Litecoin as collateral. Eve agrees and sends Litecoin to a smart contract on the blockchain. Frank then sends $20,000 to Eve’s Litecoin wallet. The loan is now active, and the smart contract will hold the $15,000 worth of Litecoin as collateral until the loan is paid off or defaulted. This is an undercollateralized loan, as the value of the collateral is less than the value. After three months, Eve pays back the $20,000 plus interest to Frank, and Frank releases the Litecoin back to Eve.

Conclusion

In all three examples, the loans are secured by collateral, and the smart contract holds the collateral until the loan is paid off or defaulted. The main difference is the level of risk for the lender and the borrower.

A collateralized loan is considered the safest, as the lender has a guarantee in the form of collateral.

An overcollateralized loan is considered relatively safe, as the lender has a cushion of additional collateral to protect against potential losses.

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On the other hand, an undercollateralized loan is considered riskier, as the lender has less protection in case the value of the collateral drops.

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