How to Set Your Collateral Buffer

Background:

DeFi lending protocols such as Compound require borrowers to provide collateral in order to borrow. Since DeFi protocols don’t collect personal information or check credit scores, the collateral is used as protection in case the borrower doesn’t repay their loan. Most protocols will require the value of the collateral to always maintain a value greater than the loan and measure this ratio using a metric called the loan-to-value ratio (LTV). This is the ratio of your loan amount to the value of your collateral. If it exceeds a specified amount called the “Liquidation Threshold”, your collateral will likely be liquidated and claimed by the lending protocol.

Setting Your Collateral Buffer

A collateral buffer is the percentage of collateral you provide above what is required for your loan. Setting a larger collateral buffer can help you avoid the risk of liquidation.

To set a collateral buffer, you first need to know how much collateral is required for your loan. This can be determined based on how much you’re borrowing and the Max LTV allowed by the DeFi protocol. You can view the Max LTV on page 3 of the loan set up titled, “Lending Protocol” as it’s included in the card for each lending protocol along with other key terms. You calculate the amount of collateral required for your loan dividing your loan amount by the Max LTV. However, Rocko automatically calculates this value for you and displays it in your loan summary table after you select the lending protocol for your loan.

It’s important to note that the LTV ratio at which your loan will be liquidated may be greater than the Max LTV. For example, a loan may have a max LTV of 82% and a Liquidation Threshold of 90%. This means that the borrower’s loan may not exceed 82% of the value of the collateral at origination. However, liquidation would not occur until the LTV is 90%. This provides a cushion for each new loan to reduce the chance of liquidation.

Since the collateral buffer is based on the Max LTV (and not the Liquidation Threshold), it means that even if it drops to 0% during your loan, your collateral may not be liquidated without the LTV dropping more. However, given the volatility of crypto and the downsides of liquidation, many borrowers prefer to set a larger collateral buffer. Generally, a larger collateral buffer reduces the possibility of liquidation as it means that the price of your collateral asset will need to decrease by a greater amount in order for liquidation to occur.

The amount for your collateral buffer is a personal preference. Some borrowers who have shorter-term loans and check their loan many times throughout the day may be comfortable with a smaller collateral buffer. For those who have longer-term loans or just don’t want to worry about constantly checking their loan, they may prefer a larger buffer. Many borrowers will use the estimated liquidation price when setting their collateral buffer and choose a collateral buffer where they don’t think it’s reasonable that the liquidation price will be hit. Rocko automatically provides the estimated liquidation price in the loan summary table when setting up your loan. Test out different collateral buffer values on page 4 of loan set up, titled, “Collateral Buffer” and the estimated liquidation price will automatically update.