Through seeing advertisements for projects like "Falcon Finance", many investors are prompted with a fundamental question: How can new stablecoins remain stable and secure amid significant market fluctuations? The recurring answer is "overcollateralization". But what does this actually mean and why is it essential in the world of DeFi?
🛡️ Overcollateralization Principle
In its simplest form, excess collateral means you provide collateral worth more than the amount you are borrowing or receiving. For example, if you want to obtain a stablecoin worth $1,000, you may need to deposit digital assets (like Ethereum) worth $1,500 as collateral.
· Reason: Risk management. Cryptocurrencies are highly volatile. If the value of the collateral you provided drops, there is a "safety margin" that protects the system from losses. Without this margin, any slight drop could lead to a shortfall in covering the loan.
⚙️ How does it work in practice?
This process is fully controlled through smart contracts, which are self-executing programs on the blockchain:
1. You deposit excess collateral.
2. The protocol issues stablecoins (like USDf in the Falcon example) based on a predetermined ratio (e.g., 150%).
3. The smart contract continuously monitors the value of your collateral. If its value falls below a safe threshold (e.g., 110%), part of your collateral may be automatically liquidated to pay off the debt and protect the system. This is known as the "liquidation" process.
⚖️ Pros and Cons of Excess Collateral
This model comes with trade-offs:
Pros:
· Greater security: Significantly reduces the risk of default for lenders or stablecoin holders.
· Stability and security: It enhances trust in the stability of the currency, even in bearish markets.
· No need for credit checks: The system relies on mathematics and assets, not on an individual's credit history.
Challenges:
· Low capital efficiency: Requires freezing a large amount of capital (collateral) to obtain less liquidity.
· Complexity for users: Understanding the mechanisms of ratios and liquidation is essential to avoid unexpected losses.
💎 Summary
Excess collateral is not a magical innovation, but rather a smart protective mechanism that compensates for the absence of a central intermediary (like a bank) in the DeFi world. It is the shield that protects many protocols from market volatility, but at the same time imposes a cost on the user in the form of freezing larger capital.
