Overcollateralization

Overcollateralization means backing a loan or a token with collateral worth more than the amount issued, creating a safety buffer against price swings. It is the standard design in DeFi lending because smart contracts cannot assess a borrower's creditworthiness — the excess collateral, not the borrower's reputation, is what protects lenders.

A concrete example: to borrow 100 DAI from MakerDAO (now Sky) using ETH, a user must lock ETH worth substantially more than 100 dollars — historically at least 150 percent of the debt, and prudent users post far more. If ETH drops and the buffer thins past the protocol's threshold, the position is liquidated: collateral is sold to cover the debt before it can go underwater. The same logic applies on Aave and Compound, where each asset has a maximum loan-to-value ratio well below 100 percent.

A common misconception is that overcollateralized borrowing is pointless — why lock up 150 to sell 100? The answer is that borrowers usually don't want to sell: they want liquidity while keeping exposure to their asset, or leverage, or to avoid a taxable sale. The buffer's size reflects the collateral's volatility: stablecoins need thin buffers, volatile tokens thick ones. When crashes move faster than liquidations, buffers can still fail, producing bad debt — overcollateralization reduces risk but does not eliminate it.