In the crypto-backed loans area, the collateral is a cryptocurrency that the borrower guarantees to repay the loan. In traditional banking, a common example is a mortgage collateral – the financed asset (house, apartment) is usually also the collateral securing the loan.
The backing process works in a similar way in crypto. When you want to borrow cryptocurrency and the lender wants to mitigate their risk, they ask for collateral. Since the communication between the lender and the borrower takes place on the blockchain, collateral tokens are created. Borrowers deposit a set amount of one asset (BTC, ETH...) to receive a set amount of another asset (USDC, USDT...).
There are many collateral assets these days. The collateral asset required is determined by the platform.
With the rise of DeFi, the need for a modern blockchain-based lending system became apparent. While the traditional world of lenders has collateral as insurance for their investment, this was not the case with cryptocurrencies at first. As the blockchain space evolves and becomes more affordable, cryptocurrencies gain in appeal, and hence the need to lend with confidence.
Collateral assets are a great way to solve the high-risk problem that crypto lenders face. By accepting a deposit in collateral assets, they are assured that even if the loan is unpaid, they will receive a part of the capital back. Depending on the loan type and collateral assets required, the certainty can be quite high.
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Collateral assets are an important part of the cryptocurrency and blockchain ecosystems. They have their foundations in traditional finance, which they carry over into the ecosystem of crypto loans.
More liquidity is coming to DeFi thanks to collateral. Users do not have to sell their cryptocurrencies. They entrust them to a lending platform, and they usually take collateral in stablecoin with which they can continue to operate. This will multiply their earnings. It's not a bad system – until more market volatility comes in, your collateral cryptocurrency loses some of its value, and you get a margin call. Always think and calculate whether you can maintain your position during higher market volatility. This will prevent you from losing money.