Collateral

Collateral is an asset a borrower locks into a protocol to guarantee a loan, which the protocol can seize and sell if the loan is not maintained. In DeFi, collateral replaces credit checks entirely: because smart contracts cannot assess trustworthiness, they demand assets upfront and enforce repayment mechanically through liquidation.

A concrete example: a user deposits ETH worth 10,000 dollars into Aave and borrows 5,000 dollars of USDC against it. The ETH stays locked while the loan is open. If ETH's price falls far enough that the collateral no longer comfortably covers the debt, liquidators repay part of the loan and take a corresponding slice of the ETH, plus a bonus, restoring the position to safety. The borrower keeps the borrowed USDC but loses some collateral.

Collateral quality matters enormously to a protocol's health. Volatile or illiquid tokens make poor collateral because their value can collapse faster than liquidations can process, leaving bad debt. This is why lending protocols assign each asset a maximum loan-to-value ratio and why stablecoins and major assets like ETH dominate collateral markets. A common misconception is that posting collateral means the protocol trusts you — it is the opposite: the entire system is built on the assumption that no borrower can be trusted, only their locked assets.