What is collateral in crypto?

Think of a pawn loan: the lender holds collateral so it can cover its claim if something goes wrong. In crypto, instead of a physical item, you might lock up ETH, Bitcoin or stablecoins. What is accepted, and on what terms, depends on the platform.

For example, suppose you deposit €1,000 worth of ETH in a lending app and borrow €500 worth of stablecoins. You’ve put up more value than you borrowed. This is called overcollateralization and it creates a buffer against price swings. The amounts here are illustrative, not actual lending terms.

In decentralized finance (DeFi), the collateral is usually managed by a smart contract. On a centralized platform, the provider manages it. Once the debt and related charges are repaid, the collateral can be released according to the service’s rules.

Why it matters

Collateral lets you borrow without first having to sell the crypto you lock up. It is also used in leveraged trading, where it backs the obligations of an open position, as well as in some stablecoin issuance systems.

We consider one distinction crucial: collateral mainly protects the lender or the system, not the depositor from losses. The locked coins are still exposed to price risk and aren’t necessarily available to transfer or use freely.

What to watch out for

If the value of the collateral falls or the debt grows because of interest, the platform’s safety threshold may be breached. A forced liquidation can then be triggered: part or all of the collateral is sold to cover the debt, possibly with extra fees.

Don’t assume you’ll get a warning first or that you’ll have time to react. Check the liquidation threshold, how prices are calculated and which other funds in the account can be used as cover. Even a stablecoin used as collateral carries risks, such as losing its peg to the reference price. There are also risks of a bug in the smart contract or of the provider being unable to return funds.