Efficiency of Over Collateralized Trading Positions: The Good, The Bad And The Ugly

Over-collateralization is an essential mechanism underpinning borrowing and lending in DeFi. Borrowers deposit collateral to access loans, which are set up as over-collateralized arrangements. This means the asset value deposited by a borrower must be higher than the loan amount they receive.

The practice protects traders from the often extreme price fluctuations typical of cryptocurrency markets. Over-collateralized positions enable borrowers to build a buffer that safeguards liquidity providers and lenders in case the collateral’s value suddenly plummets.

How to build an over collateralized position on a trading platform

Let’s say someone is worried about inflation hitting the US dollar. They can deposit a cryptocurrency of choice, borrow US dollars, exchange the USD for that crypto, and deposit it back into the lending dApp. This way, they take a bearish position on the dollar while increasing their exposure to the crypto asset.

If their prediction comes true and there is a spike in inflation, the price of the crypto asset should increase by at least the amount of inflation while the amount in US dollars stays constant. The trader can use the profit on the crypto they borrowed to repay the US dollar loan and still have the crypto and the profit from the original crypto deposit left.

Let’s see a practical example. After choosing a platform that allows for over-collateralization, a trader could deposit ether worth $1,500 and borrow USDC for $500, which comes to a collateralization ratio of 300%. If the price of ether drops significantly, there is a buffer of 150% before reaching the liquidation threshold.

Platforms typically accept ether, Bitcoin, or stablecoins. Stablecoins are less volatile than other cryptocurrencies, which is one reason they appeal to institutional lenders. Moreover, their value is easier to predict, making them more suitable for loans as this reduces the risk associated with assessing collateral value.

Platforms like Dolomite offer tools that have become integral to modern lending systems. Some of these tools continually assess the liquidity of collateral assets, allowing lenders to monitor collateral value and market conditions in real time.

In DeFi lending, over-collateralization ratios serve as crucial metrics that determine the value of collateral required with respect to the loan amount. They are always above 100% to protect the trader from market volatility. Each platform determines these ratios based on historical volatility data, market conditions, and the perceived risk of collateral type. If the platform sets a collateralization ratio of 150%, the trader must provide an asset worth at least 150% of the amount borrowed. They can then exceed the minimum ratio to be over-collateralized by providing collateral worth 200% or more of the loan amount.

Fully automated borrowing is soon to become reality

The process of borrowing an asset will become fully automated in the immediate future with Dolomite’s new “Zap” feature. Increasing leverage on an asset by borrowing against it and then buying it is quite tedious. Depositing collateral, borrowing against it, withdrawing from the platform, getting more collateral and depositing it, borrowing again, and so on until the desired leverage is reached will all be reduced to a single step. Zap will also make it possible to use collateral to pay off debt in a position instead of unwinding a borrow position by reversing the looping process. Zap will use a DEX aggregator to perform these trades, and users won’t face liquidity issues.

Margin traders must open a leveraged position. The amount they can borrow depends on the platform’s loan-to-value ratio. A ratio of 45% means they can borrow up to 45% of the collateral deposited. If the value of the borrowed asset increases or the value of the collateral drops, the position could be liquidated. To avoid this, traders must regularly monitor the ratio. The trader repays the loan plus any fees or interest to close the position. They withdraw their collateral once the loan is repaid.

The bad and the ugly

Let’s say a trader deposits ether worth $20,000 as collateral to borrow USDT worth $1,000. This is a classic example of inefficient over-collateralization, with the ratio of 2000% being significantly higher than the typical requirement of 150–200%. The trader locks up a large amount of capital without leveraging it effectively.

Using a borrowed asset as collateral is even riskier and less efficient. It seems counterintuitive, but a trader might borrow an altcoin worth $5,000 against ether worth $10,000. They redeposit the altcoin as collateral to borrow more ether. Using a borrowed asset to secure further borrowing compounds risk. If the borrowed asset’s value falls, it triggers liquidation across multiple layers.

Borrowing, redepositing, and reborrowing accrue high fees and interest rates, eating into any potential gains. The user ends up exposed to both the collateral’s volatility and the borrowed asset’s performance, doubling the risk. A collateral or borrowed asset price decline could wipe out all initial capital in a downright ugly scenario.

Opportunities beyond lending and borrowing

Dolomite only allows margin and spot trading of ETH-USDC, but once it integrates the aggregator, users will be able to swap practically any asset with external liquidity, doing away with the risk of slippage and limited markets. It will offer margin trading on assets not available anywhere else.

Users will be able to deposit ether and USDC and earn lending interest, then add those assets to a liquidity pool and earn trading fees. They can make money from lending out the USDC-ETH liquidity pool token. In addition, with Dolomite’s integration into Berachain through the Royco Pre-Deposit Campaign, users will have further opportunities to maximize capital efficiency. Berachain’s Proof of Liquidity mechanism and Dolomite’s lending technology create an added synergy to enhance borrowing, lending, and trading within the ecosystem.

Finally, collateral can be used to vote, stake, or earn rewards even as one borrows against it. The platform passes the rewards on to its users.

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