Given recent events with the implosion of crypto lenders in Celsius, 3AC, and Voyager, lending is front and centre in people’s minds. Collateralisation is a central mechanism for securing loans, whether it’s crypto or traditional finance.
It involves the provision of assets that act as security, otherwise known as collateral, to ensure the lender doesn’t lose out on the valuation of their loan if the borrower were to default on their repayment. In most traditional loans, the borrower is required to provide collateral that exceeds the sum of the loan (over-collateralisation).
However, some DeFi protocols use smart contracts to reduce the value of collateral below the sum of the loan (under-collateralisation), without impeding the integrity of the loan. In the case of Celsius, the crypto lending platform sanctioned loans with assets that they themselves borrowed from DeFi protocols. Think of it as paying off the debt of a credit card with another credit card.
This model worked during the bull market when asset prices ballooned, with the market cap of the crypto lending system reaching unprecedented heights of $110 billion in November 2021. Now, it is proving to be an unsustainable model, with many crypto lenders facing liquidation and struggling to pay off their debt.