Any lender, be it bank or a friend, wants assurance that they will get their money back.
One such way to do this is for the borrower to pledge an asset that the lender can repossess if the borrower defaults.
This is called collateral.
But how does the lender determine how much value in collateral is needed to cover the loan?
Collateral ratio, or collateralization ratio, is a measure that shows the amount of collateral that a borrower provides relative to the size of the loan.
The collateral ratio is used to assess the level of risk associated with a loan and the ability of the borrower to repay the loan.
A higher collateral ratio indicates that the borrower has provided more collateral, which reduces the risk for the lender and may result in more favorable loan terms.
The collateral ratio is calculated by dividing the market value of the collateral by the loan amount:
Collateral Ratio = Market Value of Collateral / Loan Amount
For example, let's say a borrower is seeking a loan of $100,000 and is providing a real estate property worth $150,000 as collateral. The collateral ratio would be calculated as follows:
Collateral Ratio = $150,000 / $100,000 = 1.5
This means that the market value of the collateral is 1.5 times the amount of the loan, which is considered a relatively safe collateral ratio.
Another example, if a borrower is seeking a loan of $50,000 and is providing a car worth $25,000 as collateral, the collateral ratio would be calculated as follows:
Collateral Ratio = $25,000 / $50,000 = 0.5
This means that the market value of the collateral is only half the amount of the loan, which may not be considered safe by the lender.
In such a case, the lender may require the borrower to provide additional collateral or may reject the loan application altogether.
A safe collateral ratio is one that provides a reasonable level of protection for the lender and reduces the risk of default.
Generally, a collateral ratio of 150-200% is considered safe and sufficient for most loans.
This means that the market value of the collateral is 1.5 to 2 times the amount of the loan.
However, safe collateral levels are difficult to judge when the value of the collateral is subject to volatility.
It is also dependent on the level of risk the particular lender is willing to take on.
For example, if a house is used as collateral, its value can potentially drop by upwards of 50% depending on market conditions.
Therefore, it is wise to have a collateral level well above 150% in case of a market downturn.
When dealing with cryptocurrencies, a temporary market downturn of 75-95% isn’t just possible, it’s commonplace.
Therefore, even higher collateral levels, upwards of 1000% is advisable.
Centralized Exchanges and Banks should at minimum hold a 1:1 ratio between assets and liabilities in order to remain solvent.
If they hold less assets than liabilities, they run the risk of not being able to pay their customers during a bank run.
We saw this multiple times in 2022 with exchanges such as Celsius and FTX, and we expanded on this in our recent article on Proof of Reserves and Why They Are Important.
Overcollateralization is a situation where the value of the collateral provided by a borrower exceeds the amount of the loan. This means that the collateral ratio is greater than 1:1 or 100%.
For example, if a borrower seeks a loan of $100,000 and provides collateral worth $150,000, the collateral ratio would be 1.5, which represents overcollateralization.
In the Liquid Loans protocol, borrowers deposit PLS coins in a smart contract and borrow USDL.
The protocol is designed in such a way that the value of the total PLS in the system can never exceed the total value of circulating USDL.
Therefore, the total system is always overcollateralized at minimum 110% which ensures its solvency.
Collateral ratios, or collateralization ratios, are important to understand for both borrowers and lenders.
Lenders need to know that if a borrower defaults on their loan, that the collateral at worst equals 1:1 the value of the loan.
In the case of Liquid Loans users, they need to understand that the USDL they borrow is always fully-backed and redeemable for $1 worth of PLS.
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Disclaimer:Please note that nothing on this website constitutes financial advice. Whilst every effort has been made to ensure that the information provided on this website is accurate, individuals must not rely on this information to make a financial or investment decision. Before making any decision, we strongly recommend you consult a qualified professional who should take into account your specific investment objectives, financial situation and individual needs.
Connor is a US-based digital marketer and writer. He has a diverse military and academic background, but developed a passion over the years for blockchain and DeFi because of their potential to provide censorship resistance and financial freedom. Connor is dedicated to educating and inspiring others in the space, and is an active member and investor in the Ethereum, Hex, and PulseChain communities.
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