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Collateralization
Collateralization is the process of securing a loan by locking up assets as collateral. In the cryptocurrency space, collateralization is essential for decentralized lending platforms, where users can borrow funds by depositing their cryptocurrencies into a smart contract. The value of the collateral must typically exceed the loan amount to account for the volatility of the cryptocurrency markets.
For example, users on platforms like Aave or Compound can borrow stablecoins by collateralizing their ETH or other crypto assets. If the value of the collateral falls below a certain ratio, the borrower may face liquidation, meaning their collateral is sold off to cover the debt. Collateralization allows users to access liquidity without selling their crypto, but it also carries the risk of losing the collateral if market conditions deteriorate.
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