Unwinding The Paradox Of Over-Collateralized Weakness In DeFi

From financemagnates

Collateral, and in particular over-collateralization, is a fundamental mechanism that’s necessary to secure all lending and borrowing activities in decentralized finance.

Collateralization is essential for DeFi and the basic concept is simple enough. By depositing more capital than you intend to borrow, the process protects lenders from the risk of the borrower defaulting. The only benefit for borrowers was that collateral allows them to access loans in the first place, but newer protocols like Dolomite are emerging that can extend the benefits of over-collateralization to both sides.

What is over-collateralization?

In the DeFi ecosystem, protocols cannot utilize traditional credit scoring systems due to its decentralized nature, which essentially means users are anonymous. So to facilitate access to loans, users are required to deposit collateral, in the form of cryptocurrency tokens.

DeFi loans are therefore structured as over-collateralized arrangements, and involve the borrower depositing crypto assets that are greater in value than the amount they intend to borrow. It’s a necessary practice due to the high volatility of crypto, where asset prices can and do fluctuate by significant degrees in very short periods of time. The over-collateralization process creates a buffer that offers protection to liquidity providers and other lenders, in the event that the value of the collateral declines sharply.

Collateralization is essential for DeFi and the basic concept is simple enough. By depositing more capital than you intend to borrow, the process protects lenders from the risk of the borrower defaulting. The only benefit for borrowers was that collateral allows them to access loans in the first place, but newer protocols are emerging that can extend the benefits of over-collateralization to both sides.

In most DeFi protocols, these safeguards extend to liquidation. Should the collateral’s value fall below a minimum threshold, the loan will be liquidated, meaning the collateral is sold and users to repay the lenders, unless the borrower is willing to deposit more to ensure their total deposit meets the minimum requirements.

Of course, the over-collateralization model is far from ideal, as it obviously excludes those who perhaps need financing more than anyone else – those who don’t possess the collateral to begin with. Nevertheless, it’s crucial for most lenders, especially traditional institutions, who are required to operate in systems with robust risk mitigation frameworks. The collateral cushion provides peace of mind that loans are always fully-secured, even when the underlying asset is susceptible to rapid and unpredictable price changes.

How does over-collateralization work?

DeFi loans benefit from even more guarantees when stablecoins are used as the primary collateral. Stablecoins that are pegged to traditional assets like the U.S. dollar, the euro or even traditional commodities like gold are much less volatile than other kinds of crypto assets. As such, stablecoins are a much more stable form of collateral, further reducing the risk associated with collateral value.

The use of stablecoins as collateral also protects borrowers, who face substantial risk if the value of their collateral declines sharply and they’re unable to deposit more to cover the deficit.

In addition, over-collateralization is also the process through which stablecoins are minted.

An example of this is the  DAI stablecoin , which is pegged to the U.S. dollar and operates a loan and repayment process that utilizes an  over-collateralized debt position  through MakerDAO, which secures digital assets as collateral on-chain. With MakerDAO, users can deposit Ether or a number of other accepted tokens and borrow against the value of those assets to mint new DAI tokens.

Other stablecoins, like USDT and USDC, are backed by fiat collateral held by their backers, the companies Tether Ltd. Inc. and Circle Internet Financial Ltd.

Enhancing over-collateralization

The basic over-collateralization process is simple enough to understand, but it can lead to a lot of headaches for DeFi borrowers when they’re trying to engage in complex yield-farming activities. For instance, DeFi users will often borrow funds from protocols to enable them to maximize their staking rewards for proof-of-stake tokens, or pay off other debts.

The challenge is that DeFi protocols don’t offer any kind of seamless process for this, and users are forced to do everything manually, which makes the entire process overly complicated, increasing the borrower’s risk of liquidation.

Fortunately, some protocols are working to streamline these processes to enable borrowers to maximize the capital efficiency of their collateral. With  Dolomite  for instance, users can take advantage of a process that’s similar somewhat to rehypothecation, where borrowed assets can be re-collateralized as a deposit for additional loans.

As an example, someone can go to Dolomite and deposit yield-bearing jUSDC tokens as collateral for a USDC loan. If the user deposits 100 jUSDC, they’ll be able to borrow 70 USDC, and then use that USDC to purchase additional jUSDC. As such, they’ll be left holding 170 jUSDC, increasing the APR they can earn on their jUSDC holdings.

That additional jUSDC can then be added to the original borrow position, so they would then hold 170 jUSDC. It’s possible to repeat this process a number of times to maximize capital efficiency, earning up to 70% APY, and thanks to Dolomite’s  novel Zap feature , which automates complex transactions, this entire process can be performed just once, rather than the user continually withdrawing funds, buying more jUSDC, depositing, and doing it all again.

A similar process can be used not to increase APY, but instead gain more voting rights by accumulating more governance tokens, such as through the vote-enabled vARB token, which is a derivative of Arbitrum’s native ARB token.

vARB uniquely allows users to borrow against their ARB deposits while participating in governance voting on the Arbitrum network. While ARB can be lent, borrowed and used as collateral, it cannot be used for voting when it's locked up in protocols, whereas vARB tokens can be used to vote on governance.

A user can go to Dolomite and convert 100 ARB tokens to vARB, which can then be used as collateral to borrow 400 ARB via the Zap feature. After borrowing 400 ARB, this can then be converted into 400 vARB, with 400 ARB of debt. The collateral will increase in the same proportion as the borrower’s debt, ensuring there’s no risk of liquidation due to asset price volatility.

Dolomite’s platform is therefore much more versatile than other protocols, such as Rodeo Finance, which enable the leveraged farming of assets such as jUSDC, GLP and plvGLP, but with little by way of flexibility. With Dolomite, users gain more control over the leverage and the assets used as collateral, and they won’t lose any of the rewards those assets generate, as everything is passed onto the user.

Dolomite also sets itself apart in the way users can take advantage of their assets functionality even when they’re deposited as collateral. So, someone who deposits jUSDC to borrow USDC will still be able to use their jUSDC to vote or stake or earn other types of rewards. The value is further enhanced by Dolomite’s novel “rinse and repeat” capabilities, enabling borrowers to go through multiple cycles to maximize capital efficiency while minimizing any liquidation risk.