In cryptocurrency, collateral tokens are used as a risk mitigation asset when borrowing other types of crypto tokens.
Just like with collateral used in traditional finance, collateral tokens serve as a risk-mitigating asset for lenders when borrowers want to get a crypto loan. Traditionally, collateral is an asset that can cover at least a portion of the loan the borrower is taking. The most common form of collateral is property. For example, when taking out a mortgage to buy a new house, you are actually offering the house as collateral, in the event you cannot repay that mortgage.
In crypto, the process of collateralization works in relatively the same way. When you want to borrow cryptocurrency and the lender wants to mitigate their risk, they ask for collateral. Since the lender-borrower communication happens on the blockchain, collateral tokens came into existence. Essentially, borrowers deposit a set amount of one token in order to receive a set amount of a different token, for example, BTC or ETH.
There are numerous collateral tokens nowadays. The collateral token a borrower needs to deposit is determined by the loan platform. For example, one of the more recognizable collateral tokens at the moment is COLL, or Collateral Pay. The token was specifically designed to serve as a collateral token, and it allows holders to pay for goods and services with fiat, borrowed against their COLL holdings.
With the rise of decentralized finance (DeFi), a need for a modern-day, blockchain-based lending ecosystem has become apparent. Thanks to collateral tokens, building this ecosystem becomes more achievable. While traditional lenders have had collateral as insurance for their investment, this was not the case with crypto in the beginning. As the blockchain space becomes more widely accessible, and cryptocurrencies gain traction, lending with security was needed.
Collateral tokens are a great way to solve the high-risk problem crypto lenders face. By taking a deposit in collateral tokens, lenders have the security that even in the scenario of a defaulted loan, they will receive some capital back. Depending on the type of loan and the collateral tokens required, the security deposit might be quite substantial. Additionally, as is the case with COLL, crypto enthusiasts can also use their collateral tokens to pay for goods and services in fiat. This level of flexibility is incredibly beneficial for crypto investors, as it gives them a versatile portfolio that can be utilized on a daily basis.
Collateral tokens are an important part of the cryptocurrency and blockchain ecosystem. They have their foundation in traditional finance, but build on that foundation to bring lending into the crypto ecosystem.
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