Collateralization is the process of using one asset as insurance for securing a loan in a different asset.
In modern finance, collateralization is one of the most popular insurance mechanisms that lenders require in order to give a loan to a borrower. With loans for more substantial amounts, lenders often find themselves in a situation where the risk of a defaulted loan is too great. This is where collateralization comes in very handy.
In simple terms, collateralization is the process of offering one type of asset (this could be property, fiat currency, cryptocurrency, commodities or anything else that holds value) in order to receive a loan in a different asset.
Imagine that you are looking to purchase a first home for your family. Property is on the expensive end of the spectrum, so you might need a rather substantial loan. In this case, many traditional financial institutions would offer you a mortgage for the house you want to purchase.
In essence, you are collateralizing your future home and agreeing that the bank will take ownership of your house in the event you default on your mortgage. While mortgages are the most common form of collateralization in traditional finance, borrowers and lenders have a lot more flexibility in the crypto world.
Crypto lending platforms can accept almost any kind of cryptocurrency token as collateral in order to give a loan in different crypto tokens. Of course, in this scenario, lenders need to keep in mind that crypto tokens are volatile in nature. This means that if the lender accepted collateral in ETH, for example, and the price for one ETH token tumbled significantly, the weight of the collateral they took might not be enough to cover potential losses.
In order to mitigate this risk, many crypto lenders turn to stablecoins that are pegged to a fiat currency. Some of the most popular examples include USDT and USDC. These tokens are tied to the current value of US dollars, and they cannot drastically change in price.
Another popular choice for collateralization in crypto lending are the so-called collateral tokens. These cryptocurrencies were specifically designed to serve as collateral, which means that the lender is more secure in their investment.
Collateralization is one of the primary mechanisms lenders all over the world have in their arsenal in order to mitigate any potential losses on their investment. On the other hand, collateralization of assets is also beneficial to the borrower, as in many cases, loans with collateral have significantly lower interest rates. In crypto, there is still plenty of room for exploration when it comes to collateralization. As of recently, lenders have started accepting NFTs and other forms of crypto-assets for collateralized loans.
