What is collateralization (collateral) in crypto?

What is collateralization?

Collateralization (collateral) in crypto means that you lock up crypto or other digital assets as security to obtain a loan (usually stablecoins such as USDC/USDT) or to open a leveraged position. You can think of it as a type of loan. If the value of your collateral drops too far, you will be liquidated. This means that the protocol sells your digital assets (or part of them) to secure the loan.

With a collateralized loan, you pledge an asset as security. That asset can be many things: a house, a car, savings, securities (stocks/ETFs), machinery, or even company real estate. Because the bank or lender has something “to fall back on,” the risk of loss is lower. This generally makes this type of loan cheaper than an unsecured loan, such as many credit card debts or some personal loans. Loans always involve risks, and we therefore do not recommend taking out such loans without thoroughly researching the risks.

In short:

• You borrow money
• You provide an asset as collateral
• You pay interest + repayment
• If something goes wrong, the lender can seize and sell the collateral (depending on contract and legislation)

Key Takeaways

• With collateralization in crypto, you lock up crypto (or other digital assets) as collateral to obtain a loan (often in stablecoins) or to trade with leverage. If the value drops too far, the protocol can sell your assets (partially) through liquidation.
• The value of your collateral is continuously determined based on the market price of the coins you deposit.
• Maximum loan amount (advance rate/LTV): you can usually only borrow a portion of the collateral value (often between 70-90%) so that there is a buffer for price drops and costs.
• Agreements and execution: in traditional loans, the terms are set out in a contract. In DeFi, this often happens automatically via smart contracts, including when intervention occurs and how proceeds are distributed.
• For lenders, the risk is reduced (often lower interest rates and higher approval chances for borrowers), but you are putting a valuable asset at risk and can lose the collateral if prices fall or in case of default.

How does crypto collateral work?

Valuation (assessment)

The lender first looks at the value of the collateral. For a house, this is done through an appraisal; for a car, through market value; for business assets, through valuation reports or depreciation tables. With crypto, this concerns the value of the deposited number of coins.

Advance rate (how much you can borrow)

Next, the lender determines which portion of that value may be used as the basis for the loan. This is often around 70% to 90% of the collateral value. This is often referred to as the advance rate.

Advance rate example:
Suppose your collateral is worth €100,000 and the lender applies 80%. Then the maximum loan amount is approximately €80,000.

Why not 100%? Because prices can fall (especially in the crypto market), selling costs exist, and there is always risk for the lender.

Contractual agreements

The loan agreement specifies exactly which collateral applies. It also describes when the lender may (or will) intervene and which steps follow if payment problems arise. In addition, it is determined how the proceeds of a possible sale are distributed: first, outstanding debt and costs are settled, and if anything remains, that remainder is paid back to you. In crypto, these agreements are often executed automatically via smart contracts. There are hundreds of DeFi protocols where users can borrow or lend, and payouts are fully automated. All rules are described in the smart contract, and no one can make changes to them. This is one of the reasons it is considered a secure way of operating.

Why does collateral exist?

Collateral is all about risk reduction. For the lender, the main risk is that a borrower does not pay. With collateralization, there is an additional route to recover the loaned funds. For you as a borrower, this usually provides advantages:

• Lower interest rates (less risk = lower price)
• Higher borrowing capacity (you can often borrow more)
• Higher approval chances (especially if your credit score is weaker)

The downside: you are putting something valuable at risk.

Examples of collateralization

Collateralization means that you provide something as collateral to make a loan or financing possible. This collateral gives the lender security: if you do not (or no longer) pay, the collateral can be sold to recover (part of) the debt.

Mortgage: your home as collateral
This is the most well-known form. If you consistently miss payments, the bank can sell the house through legal procedures to recover the loan.

Car loan: your car as collateral
Also very common. In case of default, the financier can repossess and sell the car.

Business loan: business assets, inventory, or real estate
Companies often use assets as collateral to raise capital for growth, renovation, or expansion. Think of machinery and equipment, company vehicles, inventory, outstanding invoices (receivables), or a company building.

Bonds: debt securities with (possible) collateral
A bond is essentially a loan: investors lend money to a company or government. Some bonds are (partially) backed by assets of the issuer. If payments are not made, certain assets can be sold to (partially) repay bondholders. More security for investors often means the issuer can offer lower interest rates.

Examples of collateral in crypto

In crypto, collateral is often used for loans (borrowing/lending) or for issuing stablecoins. The collateral is usually locked in a smart contract so that rules can be enforced automatically.

Crypto as collateral for a loan
For example BTC or ETH that you “lock” to obtain a loan in another coin or stablecoin.

Stablecoins with crypto collateral
For example, a stablecoin that is issued when someone deposits ETH or other crypto as collateral, often with overcollateralization (more collateral than the value of the stablecoin). Imagine you want to borrow €1,000; you might have to deposit €1,300. This is called overcollateralization and is very common in the crypto market.

LP tokens as collateral
Liquidity provider tokens (LP tokens) from DeFi can sometimes also serve as collateral, although this involves additional risks (such as volatility and impermanent loss).

Tokenized assets as collateral
Sometimes tokenized versions of assets (e.g. tokenized treasuries or other RWAs) are used as collateral within DeFi protocols.

Collateral and interest: secured vs. unsecured

Because secured loans have less risk, interest rates are usually lower than for unsecured loans. Unsecured products include:

• credit card debt,
• some personal loans,
• “buy now pay later”-type credit (depending on provider and structure).

Note: exact interest rates depend on market rates, term, your profile, and the product. But the principle remains: more security = often lower interest.

Margin trading: investing with collateral

In the investment world, you encounter collateralization in margin trading. In this case, you borrow money from your broker to purchase additional investments. The collateral consists of the assets in your investment account.

How does that work?

• You have investments worth €2,000.
• Your broker allows you (under conditions) to buy more with borrowed money.
• Your existing investments count as collateral.

Margin call (important risk)

If the value of your portfolio drops too sharply, your broker may issue a margin call: you must deposit additional funds, provide extra collateral, or sell positions to reduce risk. This can happen quickly, and losses can be amplified because you are using leverage. This type of investing is extremely risky and not recommended for most people.

Risks of collateralization

Collateralization may sound safe (for the lender), but it comes with real risks for you. Below are several disadvantages you may experience as a user:

• You can lose your collateral
  In case of persistent default, the lender can seize the collateral. This often happens automatically and very quickly, possibly while you are asleep or not paying attention. It is therefore a very risky way of operating.
• Overcollateralization / insufficient buffer
  If you borrow the maximum amount against your collateral and its value drops, you have little room to maneuver. You will need additional funds, which is often how large losses occur.
• Costs and conditions
  Appraisals, notary fees, administrative costs, and contractual restrictions can apply, especially when everything is arranged through smart contracts. If something goes wrong, there is no one who can intervene. Everything is digitally and contractually fixed.
• In investing: accelerated losses due to margin
  A price decline can lead to forced selling at an unfavorable moment, which can result in significant losses.

Benefits of collateralization

Collateralization can make borrowing easier because you provide the lender with additional security through collateral. This often results in better terms than a loan without collateral. Below are several benefits you may experience as a user:

• Higher approval chances
  The lender takes on less risk because collateral is provided. This makes borrowing more accessible, even if you would not normally be approved based solely on your creditworthiness.
• Often lower interest rates
  Because the lender has more security, interest rates are often lower than for loans without collateral. You therefore often pay less for the same loan amount.
• Greater borrowing capacity
  With collateral, you can usually borrow a higher amount. The level often depends on the value of your collateral and the agreed buffer, allowing you to free up more capital.
• Liquidity without selling
  You can unlock liquidity without selling your assets directly. For example, you keep your crypto but use it as collateral to temporarily obtain liquidity. This can be attractive if you do not want to exit your position.
• Faster process (especially in crypto/DeFi)
  Because the focus is mainly on the value of the collateral, the process can be faster. In DeFi, this can even happen almost instantly via smart contracts, without lengthy application procedures.

Final thoughts

Collateralization is the mechanism by which a loan is secured with collateral. For lenders, this reduces risk, which is why secured loans often have lower interest rates and better accessibility than unsecured loans. For borrowers, it is primarily a trade-off: better terms in exchange for the risk of losing a valuable asset in case of default. The concept appears not only in mortgages and car loans, but also in business financing, bonds, and in the investment world through margin trading. Anyone who borrows or invests with collateral should not only look at interest rates, but also at conditions, buffers, and scenarios in which the value of the collateral declines.