Clear DefinitionsUnder-collateralization
1 min read
Pronunciation
[uhn-der kuh-lat-er-uh-ligh-zay-shuhn]
Analogy
Like borrowing $100 but only pledging $80 worth of collateral, leaving a $20 exposure if the borrower defaults.
Definition
A condition where the collateral backing a loan or position is insufficient to cover its full value, increasing risk of default or bad debt.
Key Points Intro
Under-collateralization heightens counterparty and systemic risk in lending protocols.
Key Points
Collateral ratio: collateral value divided by loan value
Liquidation risk: positions can become insolvent quickly
Bad debt: under-collateralized defaults may not be recovered
Leverage: amplifies returns and losses
Example
A borrower takes a $1 000 loan with $800 collateral; a 20% market drop triggers liquidation and a $200 shortfall if the collateral sells below loan value.
Technical Deep Dive
Protocols monitor collateral using oracles for real-time prices. Liquidation engines trigger auctions or flash-loan liquidations when ratios breach thresholds. Under-collateralization metrics feed risk scoring and insurance pool calculations.
Security Warning
Rapid price movements can exacerbate under-collateralization, leading to cascading liquidations.
Caveat
Some protocols permit limited under-collateralization for trusted counterparties, trading credit risk for capital efficiency.
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