Collateral Exposure Explained
Collateral exposure is the relative risk of collateral being seized, as a function of the rising or falling value of the leverage trading strategy. If the value of the leverage trading position is declining, the collateral is at greater risk of being seized by the lender, because the borrower’s ability to repay the loan is diminishing. In a DeFi setting, the lender’s only recourse is a claim to the value of the collateral. Conversely, as a leverage trading strategy is increasing in value, the collateral exposure is decreasing.
Collateral serves as a borrower’s “skin in the game”. Because DeFi lending agreements are between anonymous participants, skin in the game is often necessary to ensure ethical behavior. Due to the lack of recourse in DeFi (strangers dealing with strangers, after all), it would not make sense for a lender to offer a non-recourse loan to a borrower without assurances that the loan would be paid back.