FOLLOW THE MECHANISM
- 1Lock collateral
Assets become unavailable for ordinary spending.
- 2Create debt
- 3Monitor coverage
- 4Repay or liquidate
Debt is reduced and collateral is released or sold.
A conceptual sequence. Real implementations can add steps, intermediaries, and conditions.
Minting against a locked position
In a common design, a user locks eligible collateral in a vault and creates stablecoin-denominated debt. Issued tokens can circulate while collateral stays encumbered. To release collateral, the borrower must satisfy repayment and safety conditions. Liquity V2’s BOLD provides a concrete example using ETH and supported liquid staking tokens. Sky’s Vat documents collateral-and-debt accounting for its vaults. These are specific mechanisms, not evidence that every stablecoin using contracts has exclusively native-crypto backing.
A buffer depends on a price
Collateral quantity is measured in token units, while the debt is measured in stablecoin units. An oracle supplies a conversion price so the protocol can assess coverage. A collateral ratio above 100% creates a buffer only at that assessed price. Rapid declines, stale oracle updates or limited market liquidity can make the amount actually recoverable lower than the displayed collateral valuation. A large nominal ratio does not eliminate those dependencies.
Liquidation is a loss-control mechanism
When a position breaches the applicable condition, a liquidator or auction mechanism can acquire collateral while repaying or covering debt. Penalties and incentives depend on the protocol and collateral type. Liquidation attempts to act before losses exhaust the buffer; it does not guarantee that sales occur in time or at an adequate price. If collateral recovery is insufficient, the system needs a defined way to allocate the remaining bad debt.
The peg needs more than collateral totals
Collateral totals alone do not set a market price. Liquity V2 also lets BOLD holders redeem into collateral at dollar face-value valuation less fees; this redemption can affect healthy loans and is distinct from liquidation. Sky provides DAI–USDS conversion and a LitePSM route involving external stablecoins such as USDC. Those routes add different price incentives and issuer dependencies. Follow each backing component and exit route instead of treating “onchain” as proof of a single collateral model.
MAKE IT CONCRETE
An illustrative collateral buffer
A vault locks 2 example tokens priced at 150 each and creates 150 stablecoin units of debt: coverage is 200%. If the collateral price falls to 90, value becomes 180 and coverage is 120%. A hypothetical 150% liquidation requirement would already be breached. These are chosen parameters, not a live Sky, Aave or other protocol threshold.
FAILURE PATHS & COMMON MISREADINGS
Where the model can break
- Overcollateralization is measured using prices that can change or be wrong.
- Liquidation and insolvency are different conditions.
KEEP EXPLORING