FOLLOW THE MECHANISM
- 1Recognize
The protocol accepts a specific asset and valuation source.
- 2Discount
Risk parameters limit credit against assessed value.
- 3Encumber
The collateral cannot be freely withdrawn while obligations remain.
- 4Recover
Liquidation exchanges collateral for debt repayment if eligible.
A conceptual sequence. Real implementations can add steps, intermediaries, and conditions.
A pledge does not freeze value
Collateral gives a lending mechanism a way to recover value if the borrower violates agreed conditions. In onchain lending, contracts commonly control pledged tokens and can transfer them during liquidation. The token amount can remain constant while its assessed value changes. An asset worth 1,000 reference units today may be worth much less when someone needs to sell it. Collateral is therefore a buffer subject to its own risks, not a guarantee that a loan is fully protected.
Three ratios answer different questions
Loan-to-value measures debt relative to collateral value and can also name the maximum entry parameter. A liquidation threshold specifies the boundary used to decide whether forced recovery is allowed. A collateralization ratio often reverses the fraction, expressing collateral divided by debt. With collateral of 1,000 and debt of 500, actual LTV is 50% and collateralization is 200%. Confusing reciprocal ratios can make a position look much safer or riskier than it is. Always identify numerator and denominator.
Quality includes liquidity and correlation
An asset can have a high screen price but too little market depth to sell without a discount. A receipt may depend on another protocol or a bridge. If collateral falls at the same time the borrowed asset rises, both sides worsen the position’s health. Correlated assets can sometimes reduce ordinary price divergence, but their relationship can break under stress. Protocol risk parameters try to account for these features; a favorable parameter is a governance decision, not a statement that failure is impossible.
Encumbrances matter as much as labels
A token can represent a claim on another pool while also being collateral in a lending market. The underlying asset is still subject to the first mechanism’s rules, and the receipt is now subject to the loan’s liquidation rules. Counting each wrapper as independent backing overstates the resources available. The liquidation process also has costs and incentives: a recoverable market value less than the displayed oracle value can leave lenders exposed. Understanding collateral means following the route all the way to assets that can actually satisfy debt.
MAKE IT CONCRETE
Illustrative two-boundary model
A collateral value of 1,000 with 60% maximum entry LTV and 80% liquidation threshold permits up to 600 of initial debt. The 800 threshold is not extra borrowing capacity.
FAILURE PATHS & COMMON MISREADINGS
Where the model can break
KEEP EXPLORING