What is collateral in DeFi lending?

In DeFi lending, a collateral is a digital asset that a lender accepts as security for offering a loan. The collateral mitigates financial background checks but leads to ineffective capital use and promotes procyclicality. This is because the lenders use your collateral to determine the amount of loan you qualify for; therefore, the loan must be overcollateralized.

If your collateral rises in value, your collateralization ratio will decrease. Consequently, your borrowing limits will lessen, and your loan amount will increase, resulting in more price appreciation and higher volumes.

However, if your collateral decreases in value and disrupts the lending plans, you will be liquidated. The damage is worse when you use the borrowed assets as collateral for another loan.