If you have been engaging with the world of finance on a serious note, then you already know a thing or two about collateralization and other complex terms that get thrown away in the market more often than you care to admit. Your knowledge about these terms and how you choose to interact with them says a lot about your financial capabilities and your investment portfolio as well.
Collateralization or collateral is an intensive term that is used not only in the stock and forex market but also in the crypto market and other such financial enterprises there are.
Collateral is a term often used by people who either want to borrow money or who lend people money, such as banks, lending organizations, and other such enterprises. Collateral refers to the idea of staking a valuable asset by the borrower to the lender in case they fail to reimburse the lender for the loan they are issuing to the borrower. It might be the working definition of the word collateral, but if you take into account the process that is collateralization, then it might sound a bit different than what collateral generally is.
This article is going to specifically target collateralization and dissect its meaning to you in a way that you will be able to understand both collateral and collateralization as a process.
What is Collateralization?
Various internet sources are going to define collateralization as a different entity than the very next source giving out its definition. But with enough due diligence and verification, the definition of collateralization across various financial enterprises is defined as a process through which a borrower chips in or pledges a pre-owned asset of theirs to the lender when asking the lender to lend them some money or other sorts of financial assets.
This is done as a reassurance to the lender that if in the near future the borrower fails to reimburse the lender for the money or financial asset he borrowed, then the lender has full authority to sell the collateral asset provided by the borrower and reimburse themselves for the loan they initially gave out. This is also true in case of the borrower fails to compliment or fulfill various lending terms drafted by the issuing authority between the lender and the borrower.
Let’s take an example to better understand this concept. Margin trading is a source of trading that is viable not only in the crypto market but in other markets such as stock and forex markets as well. In this type of trading, an investor is going to borrow money or other financial assets from a broker for the sake of buying stocks.
But to be able to do so, the lender would initially have to cast or chip away a proper sum of money into the brokerage account, and that financial element residing in the brokerage account is termed as collateral. It should either be exactly equal to or half of the financial assets that the borrower is lending from the brokerage firm.
There is another technicality here that you should be aware of, if you choose to increase the overall threshold of the collateral which surpasses the original amount borrowed from the brokerage firm, then it would act as a token of trust between you, the borrower, and the brokerage firm working as a lender and they might allow you to ask for an increased amount of loan from the lender which you can use to buy market shares.
It ultimately transforms into multiplying the overall potential gains of the investor if the price of the shares increases over time. At the same time, you should be aware that this thing works both ways, which means that if there is an eventuality that the price or value of the shares doesn’t increase, then it is going to have a negative impact on your investment portfolio.
If that happens where the price of the share is continually declining, the broker has the authority to retain possession of the collateral that you submitted earlier, and you would have to fulfill the terms of the agreement, which initially defines that you must turn over a profit to the brokerage fund to be able to claim your collateral back.
This is an extremely tricky business and is often a potential opportunity for those people who do not have the capital or the original investment to get into active trading. Margin trading is something that is filled with landmines, and you have to be extremely careful where you step your feet because one way or the other, you are going to trip some mines and get burned.
Margin trading is often left to experienced traders who have had some exposure within the original financial world, buying stocks, selling them, and or other attributes associated with this particular market.
A Brief History of Collateral
Laying your eyes on this complex terminology that is collateralization, you might be thinking if, over the years, things have changed with how collateral is collected and induced into every business agreement? The short answer to this is that no, over the years, collateral has been used in various business deals and by various organizations, and to a shock, not much has changed with how collateral is received and worked into a relative business agreement.
It has been in effect for hundreds of years, but only in the 1980s a collateral management business was launched when multiple bankers and financial institutions began to accept collateral against definitive credit exposure.
At that particular time period, the collateralization of derivatives exposure was becoming a thing and was widely accepted not only by the bankers but also by trading and financial mediums out there. This really hits off all the right nerves when it comes to collateral and its extensive use within the financial markets.
So in a way, you could redefine Collateralization by saying that it is actually the use of financial assets for the sake of securing a loan; if somehow the borrower does not honor the terms of the agreement or defaults on their loan, the lender has the authority to seize the collateral and then to sell it afterward for the sake of offsetting their damages or losses encumbered by the loan.
You can, in some capacity, compare collateralization with insurance, insurance is doing the same thing as collateral, but there is a functional difference between both. When it comes to insurance, you are paying a premium to an insurance company, say your mobile device, and if you accidentally break your mobile device or it sustains some damage on its own, then you are liable to file for the insurance money, and the insurance company is liable to give it to you.
On the other hand, if you intentionally damage your mobile phone and then file for insurance, then it is a moral conundrum because you might get the insurance amount on account of being morally inept, and you might be able to blow smoke in the eyes of the insurance company, but more often than not they actually know what is going on and they won’t clear an insurance claim before conducting their own research into the matter.
Collateralization, on the other hand, is a one-way street, you are either able to compliment the terms of your agreement, or you are not at home with it; it is as simple as that. Whenever there is a deviation from the original terms of the agreement, the contract dictates that the lender now has the authority over your collateral, and unless you pay the money that you owe to the lender, you can kiss your collateral goodbye.
How Does Collateralization Work?
It has already been established that across various financial enterprises, collateral is going to mean the same thing, but when it comes to the execution of the very process, this is where differentiation comes along. Different financial verticals are going to use collateralization according to their own understanding, and here are a few examples to help you along when it comes to an understanding the use of the term collateralization across financial sectors.
A car loan, business loan, and home mortgage are three significant instances where collateralization is required, but how these utilize this very thing and in what perspective is completely different from each other.
Each has its own payment plans, security, and interest rates along with the elements which they consider as collateral along with those that they don’t. The principle amount which is made available in a collateralized loan application is based primarily on the overall value of the collateral that is provided by the person in question. It means that you are not going to secure a loan that is going to be greater than the potential collateral that you have provided the lender with.
In general cases, the lender is only going to award you with about 70 to 90% of the total collateral value because they need to assess the damage which they would sustain in case you fail to make deposits on the loan that you have secured and vice versa.
It also means that as a borrower, you are going to get a little amount of money coming in towards you than the overall collateral that you have deposited; fail to honor the terms of the agreement, then eventually, your collateral will be swept off by the loan provider and you would actually be in more loss than you intended to be. That is why if you shake hands on a potential loan deal, then make sure that you come through to whatever agreements you have made with the lender.
Role of Collateralization in DeFi
The first thing that you need to understand here is that collateralization is completely different for decentralized finance than it is for centralized finance. The whole thing is being automated using smart contracts, and basically, most of these transitions take place on the Ether blockchain, which means that there won’t be any requirement for an intermediary or any such accelerator for the loan application to get through.
There is also less risk involved in decentralized finance when it comes to collateralization because, at the end of the day, you are creating stuff with smart contracts, and they are completely immutable in their own doing. This means that you have signed up for a dedicated smart contract and have enabled or agreed to all the investment metrics that it supports who are actually making sure that you would either get through to these dedicated terms or else your collateral would be seized off.
Open lending protocols on decentralized finance are primarily using collateralized loans and it is working as a backbone for that particular sector. There is no human being involved as the borrower in a decentralized finance transaction, for the lending protocol is actually a lending system, and you are actually borrowing from a liquidity pool that has crypto of people who have initially staked their tokens to earn a handsome fee for their participation.
These people are actually lenders, but they have delegated all the rights to lend their crypto or digital money to the lending protocol. Before you could get your hands on the dedicated loan, you would have to initially stake some of your tokens or a specific amount that is defined by the lending protocol to become eligible for the loan application. It might sound a bit tedious, but that is how decentralized finance and the crypto market in general work.
Most of the decentralized finance lending protocols out there are going to award you with over-collateralized loans, which means that you as a borrower would have to stake more than the overall amount you are willing to borrow from the liquidity pool.
With the conventional sense of the word, this doesn’t make any sense because if you want to borrow something that is going to be less both in value and quantity than what you are staking away as collateral, then why don’t use the collateral itself and completely save yourself the time hustle in pursuing a loan application.
That is a real head-scratcher for many people out there because of the fact that they wouldn’t have to go through the element of asking for a decentralized loan if they could use their collateral which initially they don’t have.
Why is the Collateral Ratio High in DeFi?
The collateral ratio is extremely hard in terms of decentralized finance as opposed to the traditional or conventional modes of finance because there is a reason for that, and that is market volatility. The volatility factor of the crypto market is just so over the top that most of the time, you don’t even get to experience true profit or returns on your original investment because volatility just swoops in like a vulture and picks away at any chance for you to turn in a profit.
That is why the collateral is so much higher when it comes to trading crypto in any of the decentralized finance protocols as compared to the traditional financial markets. Here the implication of this very thing is that some the times the investor or the original lender might run into a loss, and that is valid even when the borrower has returned their loan; this happens in the event that the overall value of the asset which was borrowed a long time ago has significantly increased over the period of time.
So if a borrower has asked for one coin of Ether and at the time of asking for a loan, the value of Ether was $10 but eventually, the value rolls all the way to $30, then the borrower has originally received $30 worth of Ether so, in a way, the lender is running the risk of getting underpaid which is fairly overcompensated by the collateral that is received from the borrower.
This significant boost in the price of the asset over time helps both the lender and receiver but suppose that the value of Ether has dropped below $10 and when the time of compensating the lender approaches, then the lender, of course, is running at a loss.
There are different collateral ratios out there that are used by the lending protocols, and at the same time, there are various liquidity penalties that are also in effect when it comes to those specific protocols because the game has to be corrected and balanced at each end of the equation or the whole system would collapse. This is not like lending someone $10 and then, at a certain period of time, getting back those $10 from them.
The dollar, or any other fiat currency for that matter, is highly stable, and they show signs of volatility only often and sometimes not even then, which is why the collateral aspect of the crypto market is such a wild party should you choose to be a part of it.
Collateralization is helping boost the trading career of many professionals within the crypto world, and if the volatility factor could be cooled down even a little bit, then it would be great not only for the DeFi business but for the prosperity of the crypto market as well.