Overcollateralization

Overcollateralization is a prudent risk management mechanism where borrowers must deposit collateral with a value significantly exceeding the amount they wish to borrow. Rather than a one-to-one ratio, users might need to deposit $150 in collateral to borrow $100 in stablecoins or other assets. This buffer protects lenders by ensuring there's sufficient asset value to cover potential price drops in the collateral without immediate liquidation, absorbing market volatility and creating a safety margin. Example: MakerDAO requires users to deposit ETH worth at least 150% of the DAI stablecoin value they wish to mint, meaning a borrower needs $1,500 in ETH to generate $1,000 in DAI. Why it matters for DeFi: Overcollateralization enables trustless lending by removing counterparty risk, allowing protocols to function without centralized gatekeepers. It directly affects capital efficiency and user returns, making it essential for borrowers to understand collateral requirements when evaluating lending opportunities.

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