Definition ∞ An Undercollateralized Loan is a debt instrument where the value of the collateral pledged by the borrower is less than the value of the loan amount. In traditional finance, this implies a higher risk for the lender, often offset by stricter credit checks or higher interest rates. In decentralized finance, such loans are generally only possible with specific trust mechanisms or reputation systems.
Context ∞ The discussion around undercollateralized loans in decentralized finance often focuses on the trade-offs between capital efficiency and risk management. While fully collateralized loans are common, new protocols are exploring reputation-based lending or credit delegation to enable undercollateralized options. Regulators are closely monitoring these developments due to the increased risk exposure for lenders and the potential for systemic instability.
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