Collateralisation

Collateralisation is the process of securing a loan or financial transaction with an asset, ensuring the lender has a claim to the collateral if the borrower defaults. In cryptocurrency and decentralized finance (DeFi), this typically involves pledging digital assets like Bitcoin or Ethereum as collateral to back loans or stablecoins. Collateralisation reduces risk for lenders and ensures that borrowers have an incentive to repay their debts.

How Collateralisation Works

When a borrower takes out a loan in a DeFi protocol, they must provide collateral to secure the loan. The collateral is held by the platform until the borrower repays the loan. If the borrower fails to repay, the platform can liquidate the collateral to recover the debt. In many cases, over-collateralisation is required, meaning the borrower must deposit more value in collateral than the loan they are receiving.

Importance of Collateralisation in DeFi

Collateralisation plays a vital role in maintaining the stability and trust of decentralized financial systems. By securing loans with collateral, DeFi platforms protect lenders from the risk of default. It also incentivizes borrowers to act in good faith, as losing their collateral would be a significant consequence of non-repayment.