Overcollateralization Ratio

The overcollateralization ratio is the proportion of collateral value to the value of the loan or position being secured, typically greater than one. It is a fundamental concept in decentralized finance that ensures loans are always backed by sufficient value, even if the collateral price drops.

A higher ratio provides more security for the lender or the protocol but limits the capital efficiency for the borrower. The ratio is monitored constantly and serves as a trigger for liquidations if it falls below a certain level.

This mechanism allows for trustless lending and borrowing without the need for traditional credit checks. It is the core reason why DeFi protocols can function without a central clearinghouse.

The optimal ratio is a balance between protecting the system and allowing users to maximize their capital. Understanding how to manage this ratio is essential for anyone participating in decentralized lending or derivative markets.