Overcollateralization is an important concept for borrowers looking to take out loans backed by cryptocurrency assets. Here is an in-depth look at what overcollateralization is, how it works, and what it means for crypto borrowers.
What is Overcollateralization?
Overcollateralization refers to the practice of posting more collateral than the value of the loan when taking out a crypto-backed loan. For example, if a borrower takes out a $10,000 loan, the lender may require $20,000 worth of Bitcoin to be posted as collateral. This 2:1 collateral ratio is referred to as 200% overcollateralization.
Lenders require overcollateralization to help offset the volatility risk associated with cryptocurrency assets used as collateral. If the price of the collateral drops after the loan is issued, additional collateral protects the lender in case of default.
Overcollateralization requirements may range from 100% to 300% or more, depending on the lender and the cryptocurrency used as collateral. The more volatile the coin, the higher collateralization percentage a lender will require.
Why is Overcollateralization Needed?
There are two primary reasons lenders require overcollateralization for crypto-backed loans:
- Mitigate Against Volatility. Cryptocurrency prices can be highly volatile. Bitcoin for example can swing 20-30% or more in a matter of days. This creates significant risk for lenders. By requiring 200-300% collateral, major price drops are less likely to affect the loan collateral value.
- Avoid Undercollateralization. Requiring overcollateralization helps avoid a loan becoming undercollateralized. This occurs when the value of the collateral drops below the outstanding loan principal. Overcollateralization provides a cushion to prevent this.
Without enough overcollateralization, even minor price drops could leave loans undercollateralized and lenders exposed. Hence the need for high collateral requirements.
Impact of Overcollateralization on Borrowers
While overcollateralization protects lenders, it impacts crypto borrowers in a few key ways:
- Ties Up Capital. Posting a large amount of collateral means borrowers have less liquidity to use for other investments and opportunities. This locked up capital could otherwise be earning returns.
- Additional Fees. Some lenders charge higher origination fees for loans with higher overcollateralization requirements. This increases upfront costs.
- Liquidation Risk. If collateral value drops close to the outstanding loan amount, borrowers may need to post additional collateral to avoid liquidation. This requires close monitoring.
- Tax Implications. Certain jurisdictions may treat collateral liquidation as a taxable event. Unexpected tax obligations can result.
Requirements for Crypto Borrowers
Given the overcollateralization needs and volatility risks, borrowers should meet these key requirements:
Comfort with Volatility
Borrowers should be comfortable with and understand the volatility patterns of the particular cryptocurrency used as collateral. Sudden swings could impact their position.
Sufficient Crypto Holdings
Borrowers need ample crypto holdings in order to meet potentially high collateral requirements. Limited holdings may not support desired loan amounts.
Be ready to post additional collateral if initial amounts posted look close to being depleted by price drops. Closely monitor collateral ratios.
Pay Interest Promptly
Making timely interest payments is essential to avoiding liquidation. Have a plan for covering interest expenses.
Qualified Tax Advice
Consult tax experts to understand potential tax obligations created by overcollateralization, collateral liquidation, etc.
While overcollateralization poses challenges, informed crypto borrowers can still benefit from using their holdings as loan collateral. But they must educate themselves and work with reputable lenders to make the process successful.